passive investing risks you need to know

Let me start by saying that I'm a big fan of passive investing. A significant portion of my financial assets are in index funds and I will continue to use them as a low cost way to generate close to market returns. This post is not meant to convince anyone to invest in, or not invest in, passive products, but rather to inform readers of certain risks they may not have considered. And as a disclaimer, I do not sell investment products and do not represent any company with the information below. These ideas represent my opinions and information I've learned through my own research.

what is passive investing?

For those that don't know, passive investing is a strategy where the investor purchases a passive product such as an index fund or ETF (exchange traded fund) that tracks the performance of a particular index.

A classic example is an index fund that tracks the S&P 500. The advantage of such a product is that it provides market level returns for a very low fee. Fees are low since the investment manager is merely tracking an index and doesn't require a significant investment in research. This differs from an actively managed product where a portfolio manager and team of researchers attempts to beat the market. This effort requires a larger cost and doesn't necessarily succeed in outperforming the market average.

The debate on active vs. passive is ongoing and won't be settled anytime soon, however, one thing that's indisputable is that a significant amount of assets have flowed out of active products and into passive products in recent years. According to Morningstar, in 2016 alone more than $500 billion flowed into passive products while $300 billion flowed out of active. Clearly there's a major shift happening. The question is what it means for us, and if there's anything we should be concerned about. While I'm a strong believer in passive strategies, I think there are risks developing that many people should be thinking about. Here are the three at the top of my mind;

Risk #1: Bubble in stock prices of underperforming companies

Back in the day the market would let a company know if they were any good. People would buy stocks of companies with strong fundamentals (think Apple) and sell, or at least not buy unimpressive companies (think AOL). This still occurs among people who choose individual stocks and actively managed products. While active managers are not always right, there is at least an attempt to buy the 'good' companies. But passive investing is very different. In the classic passive example of an S&P 500 index fund, index investors are pouring money into all 500 companies whether good or bad. Every time someone purchases shares in that index fund, companies with poor fundamentals are being bought just as much as those with great fundamentals. That's a cause for concern especially with billions and even trillions of dollars moving to passive products. We're likely over-valuing bad companies more and more every day, inflating their stock prices out of alignment with their underlying fundamentals. This creates a very real risk for everyone that owns those companies through any kind of product. At some point the market will recognize it's overvaluation and adjust accordingly. The only question is how long it will take to realize it and how hard and fast it will fall.

Risk #2: Disappearing diversification

Diversification means spreading out our assets so we're not putting 'all of our eggs in one basket'. In simple terms it's not owning one or two stocks, but owning a basket of stocks across multiple industries. I may own ExxonMobil only, but you may choose to spread your money across stocks from various sectors like pharmaceuticals, energy and financials. In that example, you're more diversified than I am, and if the energy sector collapsed you would fare better than me.

But what happens when everyone, or at least a significant portion of the investing world, are all buying the entire market through passive products? Sure, we're diversified because we own so many different stocks, but will that diversification protect us anymore? Probably not. As more and more people begin to own the entire market it creates the inevitable process of investors selling out of the entire market at the same time. When you own an index fund and you want to sell because it's time to retire or something in the market has caused you to panic, you can't just sell certain stocks. You must sell out of your entire index passive product. Such a rush to sell for economic or demographic reasons would pull down the entire market, and our perceived diversification wouldn't protect us. Perhaps it's time to think about what diversification really is.

Risk #3: Lack of social responsibility

What in the world am I talking about? Good question. Unfortunately I think this is one that a lot of people haven't thought about. When we choose individual stocks and to a lesser extent actively managed funds, we can choose to invest in companies that align with our moral, ethical and social values. To put it in simple context, when we buy an index fund we direct our money equally to both the

socially responsible companies and those that choose to throw sludge into rivers. Hopefully companies aren't really throwing sludge into rivers, but we all know certain companies have a better conscience when it comes to things like the environment and other social causes. Some people may not care but I know that a lot of people do.

Socially responsible investing is something we may start to hear a lot about in the near future. In an attempt to combat the shift to passive and garner assets from socially responsible millennials, active managers will likely begin creating new socially responsible products.

How do we protect ourselves?

First, keep an eye on the shift between different active and passive strategies. Will the shift slow down anytime soon or will this continue? If it continues, know that the risks will continue to grow too.

Understand how to limit risks and diversify under these new conditions. Owning a variety of stocks is not enough. Think about the type of investments you own, and how diversification fits into your entire net worth. Passive strategies may work for you, but should you have all of your assets there?

Do you see any additional risks developing in passive investing? Leave a comment and let us know!

Disclaimer: This post represents my opinion and is not intended to influence any reader's decision to buy or sell investments. The opinions in this post are mine only and do not represent those of any financial firm.


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