The Rise of Passive and Indexed Investing, and its Effect on Market and Liquidity Risk

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

The most profound developments in the investment markets in the last 20 years have been the growth of indexed-based investing and the move to passive fund management. Though the assets of mutual funds have increased three-fold in the last 17 years, the assets of exchange traded funds (ETFs), funds that are typically indexed, have grown 130-fold.[1]

The growth is not just in ETFs. Index mutual funds have grown in assets over this same period six-fold.[2] Index funds make up 22% of all mutual fund assets currently.[3] In contrast, in 1994 index net flows (purchases) were only 2% of all net new cash in domestic equity funds.[4] For every $1.00 that has abandoned actively managed domestic equity mutual funds since 2007, $1.20 has gone into domestic equity index funds and ETFs.[5]

Investment Company Institute. 2016. 2016 Investment Company Fact Book: A Review of Trends and Activities in the US Investment Company Industry. Washington, DC: Investment Company Institute. Available at

Within the last 10 months we have achieved a trifecta in trillion dollar milestones: April 2016 – ETF assets reached $3 trillion, October 2016 – Blackrock assets reached $5 trillion, February 2017 – Vanguard assets reached $4 trillion.

This dramatic growth offers significant opportunity for the index fund industry, but not without its risks. As assets move from active to passive management, what systemic danger lurks? What market disruptions might occur with a concentration of assets backed by monolithic indexes on autopilot? Are there liquidity risks? Are the risks safely contained within financial services, and, more specifically, the investment industry? Or, is this a ubiquitous risk that could threaten your company, and indeed the entire economy? Could this hyper-growth portend a market failure as broad and damaging as the financial crisis of 2007-2008?

Perhaps because of the inchoate nature of the index-growth phenomenon, market watchers have expressed a wide variety of opinions from “not an issue,” to an intriguing Sanford Bernstein & Co. report that warned “passive investing is worse than Marxism.”

The battle has many fronts, and no resolution.