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.
-
Four Surprising Signs You’ll Never Retire (and How to Fix Them)Gearing up to retire? If any of these four signs ring true, you may want to make some changes before you do.
-
Stocks Rise After Trump-Powell Fed Tour: Stock Market TodayNvidia hit a new all-time high intraday, but another renowned semiconductor name and some less iconic stocks were bigger movers Friday.
-
Stocks Rise After Trump-Powell Fed Tour: Stock Market Today
Nvidia hit a new all-time high intraday, but another renowned semiconductor name and some less iconic stocks were bigger movers Friday.
-
How Divorced Retirees Can Maximize Their Social Security Benefits: A Case StudySusan discovered several years after she filed for Social Security that she is eligible to receive benefits based on her ex-spouse's earnings record. This case study explains how her new benefits are calculated and what her steps are to claim some of the money she missed.
-
From Piggy Banks to Portfolios: A Financial Planner's Guide to Talking to Your Kids About Money at Every AgeFrom toddlers to young adults, all kids can benefit from open conversations with their parents about spending and saving. Here's what to talk about — and when.
-
I'm an Investment Pro: Here's How Alternatives Could Inject Stability and Growth Into Your PortfolioAlternative investments can often avoid the impact of volatility, counterbalancing the ups and downs of stocks and bonds during times of market stress.
-
Dow Bleeds Red Due to Big Blue: Stock Market TodaySix of the official GICS sectors were in the green, led by communications services, technology and energy stocks.
-
A Financial Planner's Guide to Unlocking the Power of a 529 Plan529 plans are still the gold standard for saving for college, especially for affluent families, though they are most effective when combined with other financial tools for a comprehensive strategy.
-
An Investment Strategist Takes a Practical Look at Alternative InvestmentsAlternatives can play an important role in a portfolio by offering different exposures and goals, but investors should carefully consider their complexity, costs, taxes and liquidity. Here's an alts primer.
-
Ready to Retire? Your Five-Year Business Exit StrategyIf you're a business owner looking to sell and retire, it can take years to complete the process. Use this five-year timeline to prepare and stay on track.
