Is Passive Investing Destroying The Markets?

This article originally appeared on ETF.COM here.

Passive investing has been ridiculed by Wall Street for decades. The following list is just a small sample of the criticisms I’ve collected over the years:

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Passive Investing

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The common theme is that indexing (and passive investing in general) has become such a force that the market’s price discovery function is no longer working properly. Goldman Sachs’ O’Neill has even called passive investing a “potential bubble machine.”

Given the number of questions I get from investors about this issue, one would think that passive investing is now dominating markets. Let’s see if there’s any truth to such beliefs, and whether there’s anything to worry about.

The latest research

A recent study by Vanguard found that, as of October 2017, about $10 trillion was invested in index funds. While a large figure, it represents less than 20% of the global equity market. Is there anyone who thinks the other 80% of assets are handicapped in their price discovery efforts? Even more important is that, while indexing makes up about 20% of invested assets, Vanguard estimated it actually accounts for only about 5% of trading volume. Is passive investing’s 5% share of trading volume setting prices, or is it active management’s 95% share doing so? Once you know the data, you can see how absurd the claims being made are.

While it’s certainly possible that, at some point, passive investing could reach such a dominant share that price discovery would be limited, clearly, we are nowhere near that level, and almost certainly won’t be there for a very long time.

Another important point

It wasn’t until 1950 when the number of mutual funds topped 100. That number was still only at about 150 in 1960. And hedge funds were a nascent industry. Today we have about 9,000 mutual funds and 10,000 hedge funds. Twenty years ago, hedge funds controlled about $300 billion. Today that figure is 10 times as large. Essentially, Wall Street wants you to believe that, while 60 years ago the markets were operating efficiently with only about 100 actively managed funds, the markets are no longer functioning well when we have close to 20,000 active funds.

All this criticism isn’t based on any facts. Instead, it is the result of investors waking up to active managers’ failure to add value and thus abandoning active strategies in favor of passive ones. For example, 2017 was the fourth-straight year money flowed into passive funds and out of active funds. The active industry has to fight back in an effort to at least slow the tide. That said, it’s important to note active investors have an important role to play. Thus, we don’t want them to disappear entirely.

Read the full article here by Larry Swedroe, Advisor Perspectives

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