The Consequences of Passive Investing

Summary

  • The impacts of passive investing are not as well understood as they should be.
  • Passive is not passive! It is a self-enforcing, momentum-driven systematic strategy.
  • Unless the flows into passive were to change significantly, it seems likely we are going to see a significant change in the character of markets.
  • The consequences could be destructive.

“If you push indexation to its logical extreme, you will get preposterous results” - Charlie Munger

The rise of passive investing over the past 30 has revolutionized the way investors obtain exposure to the worlds equity markets. The introduction of index funds as far back as the 1970s and more recently, the rise of exchange-traded funds since the 1990s has provided a cost effective way for institutions and individual investors alike to participate in financial markets without the need for the traditionally more costly active managers.

It is true the introduction of these low-cost investment vehicles has been beneficial for investors, resulting in passive investing becoming the primary investment vehicle of choice for many. Particularly within the past decade, we have seen flows into passive investment vehicles continue to grow at the expense of traditional active managers, leading to the rise of financial behemoths Vanguard and Blackrock. However, whilst it is rational for one to argue this rise of passive to be beneficial for investors, what these institutions claim as being a low cost way to invest may come at great cost in the long run.

Passive investing appeals to those looking for a free lunch, but as we know, there is no free lunch in financial markets.