The Potential Downsides of Passive Investing

Passive investing is gaining popularity, but some critics may have valid points. This investment strategy, involving buying low-cost exchange-listed market trackers instead of actively managing a portfolio, has become a favourite among users, from individual investors to large institutions. However, some fund managers are less enthusiastic about this trend. They argue that the rise of passive investment over the past four decades has sparked a fee war in the asset management industry and has led to unexpected consequences in the stock market.

Recent data from Morningstar revealed that, for the first time ever in December, the net assets in passive funds surpassed those in active funds. While the demand for US mutual funds and exchange traded funds in 2023 was rather weak, a significant amount still flowed into passive funds. In fact, Morningstar noted that passive funds have been encroaching on the territory of active funds for years, with the total net assets in passive funds now standing at an impressive $13.3 trillion, $8 trillion of which is held in US equities.

A study published by the US’s National Bureau of Economic Research last month also raised concerns about the impact of passive investment. The study found that the increased use of indexing has dulled the impact of news that would normally move stock prices. This could potentially have a sedating effect on the stock market, which may be a cause for concern.

The study looked at currency shocks and their impact on the stocks in the S&P 500 index, a prime target for passive investment. The researchers found that there was a significant decrease in the stocks’ idiosyncratic currency sensitivity when they were included in the S&P 500 as opposed to those that were not. This decrease also seems to be in line with the rise in passive investment. The study also suggested that increased indexing is undermining the efficient markets hypothesis, which is a fundamental principle in investment that states asset prices reflect all available information.

While passive investment does have its benefits, the growing evidence suggests that it is altering the investment landscape in significant ways. As passive investment continues to grow, the entire investment process may evolve into something separate from the traditional notion of investing in successful companies, and instead become a circular bet on more money flowing into the asset class. This could lead to faulty allocations of capital and have repercussions for both passive and active investors.

Ultimately, while passive investment has certainly opened up opportunities for millions of people to participate in financial markets, it is important to acknowledge the potential downsides and consider how it may be altering the investment landscape.