Why Passive Investing Isn’t a Panacea

The active/passive debate has been raging for years, and both approaches have merit. But there’s more to the story than meets the eye. Investors who commit too much to passive—and not enough to active—could face mounting risks.

No one disputes that passive investing plays an important role in many investors’ portfolios—especially over the past decade. Passive strategies open the door to low-cost market access. But passive’s explosive growth is creating a buildup of structural challenges, just as active investing faced structural challenges in its heyday.

Today, roughly 1,800 exchange-traded funds (ETFs) are chasing less than half that number of US stocks with a market cap over $5 billion. ETF growth doesn’t look to be slowing down, and crowding in certain stocks and market segments is likely to intensify. As investors have piled into passive spaces, specific distortions have begun to form, with the most passively held stocks becoming more volatile and more highly correlated to each other versus the broad market. And both measures seem to be intensifying.

In our view, four factors collectively magnify the risks to investors:

1) Crowding. Investors who follow the herd when making portfolio decisions tend to pile into certain stocks and market spaces. The following three factors make crowding worse.

2) Fragility. Investors in a specific market segment or trade usually expect a certain outcome. And they’ll quickly jump ship if they don’t see the results they want. Think of it as collective flight risk.

3) Liquidity. Crowds in a panic run for the exits, creating a liquidity crunch. If liquidity is drying up, how hard will it be to find a door? And how much will passive investors have to pay to open one?

4) Passive Ownership. If passive investors in an ETF want out of a crowded trade, they have to sell the entire index, regardless of individual stocks’ merits. It’s like selling the baby with the bathwater.