THE DANGERS OF PASSIVE INVESTING

?????????????????????Over the past 15 years, the most powerful trend in investing has been the growth of passive investing, which is the long-term purchase of investment vehicles whose performance is linked to a relatively fixed set of investment instruments, such as stock indices. The appeal of passive investing has not been limited to individual investors but has been embraced by pension funds and other institutional investors as well. Unfortunately, it is this extreme popularity that may produce the conditions that could expose devotees to the risk of significant losses in the years ahead.

The popularity of passive investing is understandable. Passive investment vehicles typically offer lower fees and the ability to quickly gain diversified exposure to a market or specific sector. Passive strategies are easy to implement and intellectually undemanding. That 80% of actively managed mutual funds have historically not performed as well as broad market indices have certainly contributed to the appeal of passive investment vehicles. ?Passive investment strategies now represent almost 50% of invested assets versus roughly 10% at the turn of the century.

But there are risks…….

It is noteworthy that the bulk of the growth in this pool of passive investors has occurred in a benign market environment. Except for the Financial Crisis of 2008 and the sharp, but brief, market decline of 2020, this growth has coincided with consistently positive market returns generated by unusually low market volatility.?Thus, the experience of most owners of passive investment vehicles has been a steady march higher, with minimal volatility. Indeed, stock markets for the decade of the 2010s demonstrated extremely low volatility compared with historical averages.

The ease of use of passive vehicles has reduced the desire by many people to acquire the investment knowledge obtained by study and experience. Passive investment has thus created a large pool of investors with limited skills in coping with changing investing environments.

How will these investors respond to the volatility associated with a bear market when it inevitably arrives? Investors with modest experience with market volatility and negative returns may be more disposed to emotionally-driven decisions when faced with the psychological pain imposed by a significant bear market….and this creates greater downside risk for both the passive investor and capital markets in general.

Meaningful selling from holders of passive investments has the potential to amplify market volatility, which would then generate further selling. The problem lies in the tendency of passive vehicles to concentrate their holdings in those components with the largest weightings in a bid to replicate index returns in the most cost-effective manner. This approach is understandable when one recalls that the top five companies in the S&P 500 represent over 20% of the index! Any event that prompts sustained selling by passive investors would likely amplify the declines of market indices because of the concentration of their sales in vehicles holding stocks with the largest index weightings.

Investors do not have the luxury of dealing in certainties. Rather, they deal with a spectrum of probabilities. The current era hosts an array of potential catalysts that could produce significant market volatility. Stock market valuations and investor optimism are at extreme levels. The global economy is burdened by an unprecedented level of debt, and geopolitical risks are rising. While a variety of vaccines are available to combat COVID, the potential threat posed by the emergence of new variants should not be discounted. This combination of factors suggests that the 2020s will be a very demanding decade for investors.

I believe the answer to these demands lies not in passive investing, but in investors becoming more engaged, more “active” in the management of their financial resources. The effort to become a better informed, more active investor will prove rewarding not only to those who choose to make their own investment decisions but also to those who prefer to have their money managed by others as it will improve their ability to ask better-informed questions of their advisors.

In conclusion, economic and geopolitical forces are converging, which can be expected to produce considerable market volatility in the 2020s. That volatility will ultimately reward engaged active investors and punish the complacent. Best results are seldom achieved by being passive in any aspect of life, be it our relationships, careers, health, or our investments.

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