The dangers of passive investing

There is a lot to be said for passive investing.

Key Takeaways from Morningstar’s Active/Passive Barometer Report:

  • Actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons.
  • Failure tended to be positively correlated with fees.
  • Fees matter. They are one of the only reliable predictors of success.

Prof. Burton Malkiel, author of A Random Walk Dow Wall Street, writes in the WSJ:

During 2016, two-thirds of active managers of large-capitalization U.S. stocks underperformed the S&P 500 large-capital index. When S&P measured performance over a longer period, the results got worse. More than 90% of active manager underperformed their benchmark indexes of a 15-year period.

…..In 2016 investors pulled $340 billion out of actively managed funds and invested more than $500 billion in index funds. The same trends continued in 2017, and index funds now account for about 35% of total equity fund investments.

Volatility is also near record lows as the market grows less reactive to short-term events.

CBOE Volatility Index (VIX)

Lower fees and lower volatility should both improve investment performance, so what could possibly go wrong?

Investors could stop thinking.

If passive funds are the investment of choice, then new money will unquestioningly flow to these funds. In turn the funds will purchase more of the stocks that make up the index.

Prices of investment-grade stocks that make up the major indices are being driven higher, without consideration as to whether earnings are growing apace.

And the higher index values climb, the more investment flows they will attract. Driving prices even higher in relation to earnings.

More adventurous (some would say foolhardy) investors may even start using leverage to enhance their returns, reasoning that low volatility reduces their risk.

The danger is that this becomes a self-reinforcing cycle, with higher prices attracting more investment. When that happens the market is in trouble. Headed for a blow-off.

Investing in passive funds doesn’t mean you can stop thinking.

Don’t lose sight of earnings.

When prices run ahead of earnings, don’t let your profits blind you to the risks.

And start thinking more about protecting your capital.

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