Passive investing is taking over the world. Okay, that's an exaggeration, but investment researchers at Sanford C. Bernstein & Co. say that nearly half of equity assets in the United States are passively managed, and the trend is growing. These same researchers called passive investing "worse than Marxism."
What exactly is passive investing, and why is it a problem? According to Investopedia, "Passive investing is an investment strategy that aims to maximize returns over the long run by keeping the amount of buying and selling to a minimum." Investors do this by purchasing index funds and exchange-traded funds (ETFs). So what's the problem?
Passive Investing Returns Fall Short
Index funds and ETFs have underperformed Standard & Poor's 500-stock index over the past two years, according to Steven Bregman, co-founder of Horizon Kinetics, an investment adviser firm with a "long-term, contrarian, fundamental value investment philosophy."
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Why? It could be simply the nature of these types of investments. When investors buy into an index fund, they're investing in a predetermined list of stocks. The managers of that index fund have to buy those stocks on the list without considering the valuation of those companies.
As Bregman says, the rise of passive investing "allows the herd to crowd assets and escalate their power without accountability to fundamentals." Does this sound a like a good idea?
A Factor in Bubbles and Flash Crashes
Worse yet, the rise of passive investing may be creating one of the biggest bubbles ever. A bubble can be defined as a situation where money flows in a certain direction without the movement being based on a valuation, which also seems to be one of the defining features of passive investing.
And there's another issue: Computers run index funds and ETFs. The computers buy whenever there's a dip. Those same computers sell when the trend turns the other way, and that can create an irrational panic where even more people sell. Remember the Flash Crash of May 6, 2010? That day the S&P 500 fell 7% in less than 15 minutes. This plunge was partly caused by computers selling off ETFs and index funds. Imagine the bubble—and the crash—if people continue to pour money into passive investing.
The Bottom Line for Investors
Passive investing has its champions. Index funds and ETFs can be low-cost, easy-to-buy, and well, passive—investors don't have to do anything more once they've bought in. But passive investing can also carry danger for individual investors, and maybe more importantly, for the market as a whole.
What Should You Do About It?
Be an active passive investor. Meaning that you should have a stop loss strategy for your equity holdings to protect against large losses when the inevitable bear market comes.
Also, don't forget to rebalance your portfolio quarterly so as to not become overweighted in one sector or index, which can increase your risk.
-
AI vs the Stock Market: How Did Alphabet, Nike and Industrial Stocks Perform in June?AI is a new tool to help investors analyze data, but can it beat the stock market? Here's how a chatbot's stock picks fared in June.
-
Stock Market Today: A Historic Quarter Closes on High Notes"All's well that ends well" is one way to describe the second quarter of 2025, at least from a pure price-action perspective.
-
Stock Market Today: A Historic Quarter Closes on High Notes
"All's well that ends well" is one way to describe the second quarter of 2025, at least from a pure price-action perspective.
-
Eight Tips From a Financial Caddie: How to Keep Your Retirement on the FairwayThink of your financial adviser as a golf caddie — giving you the advice you need to nail the retirement course, avoiding financial bunkers and bogeys.
-
Just Sold Your Business? Avoid These Five Hasty MovesIf you've exited your business, financial advice is likely to be flooding in from all quarters. But wait until the dust settles before making any big moves.
-
You Were Planning to Retire This Year: Should You Go Ahead?If the economic climate is making you doubt whether you should retire this year, these three questions will help you make up your mind.
-
Are You Owed Money Thanks to the SSFA? You Might Need to Do Something to Get ItThe Social Security Fairness Act removed restrictions on benefits for people with government pensions. If you're one of them, don't leave money on the table. Here's how you can be proactive in claiming what you're due.
-
From Wills to Wishes: An Expert Guide to Your Estate Planning PlaybookConsider supplementing your traditional legal documents with this essential road map to guide your loved ones through the emotional and logistical details that will follow your loss.
-
Your Home + Your IRA = Your Long-Term Care SolutionIf you're worried that long-term care costs will drain your retirement savings, consider a personalized retirement plan that could solve your problem.
-
I'm a Financial Planner: Retirees Should Never Do These Four Things in a RecessionRecessions are scary business, especially for retirees. They can scare even the most prepared folks into making bad moves — like these.
