The Danger of Passive Investing

By Vincent Lin and Richard Lee


From August to September 2019, the world was captivated by several events, from the prospect of a no-deal Brexit to a renewed push for climate change action. While these have played out on the world stage with much scrutiny, there has been a lesser known event which has signalled a fundamental shift in financial markets and in the investing atmosphere. It is when total assets in passive funds surpassed total assets in active funds in the U.S. According to Morningstar’s estimates, U.S index tracking equity passive funds experienced inflows of $88.9 billion while active funds experienced outflows of $124.1 billion, providing a $25 billion difference towards the two investing styles. Australia has also experienced something similar, with interest in the passive investing vehicle peaking over the last two years, coupled with the relatively poor performance of active fund managers to passive benchmarks. 

The debate of passive vs active has also been brought to the forefront in the current COVID-19 crisis, with the coronavirus and government intervention to combat the infection wreaking havoc on financial markets internationally. Given the increased influence of passive investing, it is only natural for this to be explored further. While passive investing does provide several benefits to certain investors and more objective advantages to active investors, it is not without it’s disadvantages and its criticisms.

What is Passive Investing?

Passive investing is an investing approach which is performed over a long-time horizon compared to that of active investing where capital is deployed for shorter periods of time. Buying and selling in an investor’s portfolio is limited to a minimum. One of the most popular ways of investing passively include buying an index fund which tracks a major index such as the S&P 500 or the S&P/ASX 200. There are a variety of index funds available to investors, from those of specific asset classes to even inverse funds which profits off market decline. 

Pros:

Low transaction costs

Low costs attached to passive investing has been one of the main reasons for the dramatic shift from active to passive funds. Minimising changes in a portfolio’s composition is an inherent feature of passive investing, which helps with reducing transaction costs and being beneficial with an investor’s returns. Active investing is at a disadvantage in this regard, with the style being ubiquitous with frequent rebalancing and changes. Passive fund managers such as Vanguard or Blackrock engage in less oversight to active ones, which is a reason for such low costs. 

Diversification

Investing in passive vehicles such as index funds involves taking a position in a basket of securities, each with individual exposure to different macroeconomic factors, asset classes, sectors and business models. Through this broad exposure, returns from a passive portfolio become less volatile and smoothed, making it unlikely for its value to significantly decrease in value, absent times of significant market stress. This benefit is called diversification and it allows passive investors to experience steady profitability over the long-run, instead of uncertain volatile returns over shorter time-horizons attached with active investing.

Simplicity

An overly complicated investing strategy can have its downsides, particularly with regards to an extensive research process and time spent. They can also reach a level of complexity that conflicting individual positions can arise. Passive investing is relatively straight-forward, with only the selection of the index fund or broad investment vehicle providing some difficulty. There is less room for ambiguity and opposing positions in an investor’s portfolio which makes for clear portfolio positioning. Furthermore, index or other passive funds are relatively easy to access and enter into, which is an important benefit for retail investors.

Low capital gains tax

When engaging in passive investing, there is a reduction in the number of trades in an investor’s portfolio. As a result, there is less capital gains tax incurred over the immediate timeframes. Additionally, holding investment for a longer timeframe (>1 year) is also subject to lower capital gain tax. This is compared to active investing, which incurs more frequent capital gains tax if positions are realised as profitable. This feature is aligned with the cost efficient nature of passive investing as a whole, which can help tremendously in terms of available capital for investments.

Cons:

Liquidity concerns

ETF’s, which are the prime instruments for passive investing, also reflect valuable information about the true state of liquidity in the markets. This is largely influenced by the demand and supply in the secondary market as well as driven by Authorized Participant’s (AP) role in arbitraging the difference between Net Asset Value (NAV) and prices. Usually, this results in low tracking errors, however, during the turmoil which we have witnessed in March, under intense selloff, the absolute deviation from NAV rose by up to 20 times in Investment Grade bond ETFs and by close to 10 times in High Yield and Emerging Market bond and equity ETFs. 

Michael Burry warns of danger of passive investing

Michael Burry, one of the main characters from Michael Lewis’ “The Big Short” has also pointed out the seemingly high liquid ETFs could face liquidity risk in the face of a drastic market downturn. The passive index funds distribute funds among the securities within the indexes, and in some cases, take the Russell 2000 Index, for example, the vast majority of the stocks are lower volume and lower value-traded stocks. Therefore, as the AUM builds up, the risk that a portion of the index may not be liquid enough to buffer any extreme selloff increases.

In that case, the tracking error could widen significantly and cause various issues. During the recent downturn, large index ETFs were relatively safe with acceptable tracking errors. However, the same cannot be said with the bond ETFs. It is documented that roughly 70 fixed-income ETFs were trading with at least a 5% discount to their NAV, and 16 traded at a discount of 10% or greater. This suggests that some of the ETTs will not function as steady, index-based products during crisis-like periods.

High yield municipal passive ETF drop
(Muni = municipal. Essentially debt issued by State government)

Influencing market behaviours

With the increasing amount of money flowing into the passive funds, it could imply that momentum stocks may be rewarded as securities that rise in price would capture an increasing fraction of each incremental investment dollar. Additionally, there could be a rise in correlation as securities become increasingly traded as a group.

Market behaviours of passive investing

Other concerns:

With passive investing, one cannot alter their exposure to individual securities during different market conditions, hence, not allowing one to capture desirable profitable positions or avoid unprofitable ones. Additionally, it also limits the investor’s capital for a long period as the nature of passive investing involves earning returns over a long time horizon, meaning one is unable to use this capital for other trading opportunities which come up during this time. Moreover, due to the fact that many indices are focused on large-cap or liquid stocks, one has to forego opportunities in small-cap or illiquid stocks, which can sometimes earn higher returns.

The rise of passive investing is changing the investment landscape. Despite the benefits that it provides, some of the embedded issues only started to surface lately. It would be interesting to witness how passive investing would continue to reshape the industry going forward.


Sources: 

https://www.bloomberg.com/opinion/articles/2020-03-23/coronavirus-bond-etfs-will-never-be-the-same-after-this-crisis

https://www.bloomberg.com/news/articles/2019-09-04/michael-burry-explains-why-index-funds-are-like-subprime-cdos

https://www.logicafunds.com/policy-in-a-world-of-pandemics

https://www.afr.com/wealth/personal-finance/why-investors-are-shunning-active-and-chasing-passive-20190923-p52tyc

https://www.investopedia.com/epic-shift-sees-passive-funds-pass-active-as-stock-pickers-retreat-4769887

https://www.investopedia.com/news/active-vs-passive-investing/

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Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a  professional before making investment decisions based off of this article.

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