Over just the last few years the proportion of the US stock market that is invested passively has moved up to 45%. Investors are attracted to ETFs (exchange traded funds) because of their low overhead. And, many have outperformed actively traded vehicles like mutual funds and other actively managed investment vehicles. But, can passive investment be risky?
Passive Investment Is on the Rise in the US Stock Market
CNBC reported that passive investing automatically tracking indexes has risen to nearly half of the US stock market.
Passive investing, made up of funds tracking market barometers, has now taken over nearly half the stock market as more investors shun stock-pickers and flock to index funds.
Market share for passively managed funds has risen to 45 percent, up a full point from June 2018, according to data this week from Bank of America Merrill Lynch. That continues a trend over the past decade in which investors have moved to indexing, particularly through exchange-traded funds.
Despite the risks that some see in this approach, investors are pleased with the results and are even applying it to buying bonds! But, can passive investment be risky? It turns out that there are valid concerns. But, first, just what investment vehicles are we talking about?
Passive Investment Funds versus Active Investment
Investopedia discusses active versus passive investing.
Active investing, as its name implies, takes a hands-on approach and requires that someone act in the role of portfolio manager. The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. It involves a much deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond or any asset.
This investment approach obviously applies to when you choose stocks yourself using an approach like intrinsic stock value. It also applies to when an investment professional oversees a fund that invests in millions or billions of dollars in stock investments.
If you’re a passive investor, you invest for the long haul. Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest. The strategy requires a buy-and-hold mentality. That means resisting the temptation to react or anticipate the stock market’s every next move.
The prime example of a passive approach is to buy an index fund that follows one of the major indices like the S&P 500 or Dow Jones.
Such investments have become popular for three main reasons. Their fees are very low because no one is getting paid to research stocks to buy and sell, an investor always knows exactly what investments are in the fund, and because there is not a lot of buying and selling, investors are not paying a lot of taxes on capital gains every year!
The Value of the Passive Investment Approach
As noted, funds that track the S&P 500 and other indexes are cheap to run and this fact shows up in a lower “investing overhead” for the passive investor. In the last few years as the bull market has exploded in the aftermath of the Great Recession the passive approach has made excellent money and often out-performed many active investors.
Here are three very large funds that qualify as passive investment vehicles.
SPDR S&P 500 ETF (SPY)
This vehicle is a unit investment trust that manages about $280 Billion in assets. It is up six times its initial value per share in 1993. Because of its huge size this fund is very liquid for those who choose to buy and sell. And, it has performed very well for passive buy and hold investors.
iShares Core S&P 500 ETF (IVV)
iShares is an ETF that manages about $165 Billion by tracking the S&P 500. It can be traded like a single stock for those who wish to buy and sell and has been good to buy and hold passive investors. IShares is trading at three times its single share value at the depths of the stock market crash but is less than double what it started at in 2000.
Vanguard S&P 500 ETF (VOO)
This fund is a true ETF that manages about $106 Billion. Is the newest of the three having begun in 2010 although Vanguard has been around for a long, long time. The shares are up to 250% of their original value.
As can be seen, these three funds are managing half a trillion dollars in stocks. The total S&KP 500 market cap is about $22 Trillion and the total US stock market cap is around $30 trillion. But, remember that there are a lot more such vehicles as of today they manage nearly half of all US stock market equity.
Now, what is the down side of this approach?
Can Passive Investments Be Risky?
Critics of the current infatuation with passive investing say that the great bull market since the Great Recession has strongly influenced our view of these investments.
Passive Investments Can Be Inflexible
First of all, these vehicles track the market and are up because the market is up. When the market falls, so will they! Warren Buffet pulled a lot of investments out of the market and held a large amount of cash just before the dot com crash. He said the market did not make any sense. He did not lose when the market crashed and was ready with lots of cash to buy bargains as the market recovered. ETFs and other passive investment vehicles will not and cannot do this as they are forced to buy and sell to maintain a mix of stocks that reflects the index that they track!
Passive Investment Vehicles May Need to Sell into a Falling Market
When the next crash comes, and it will, a well-structured ETF that tracks the S&P 500 could weather the storm and recover. But, what if its investors panic? On a normal day these funds buy and sell to adjust their mix of stocks. If just one in ten of their investors want to cash out, the selling will drive the share price lower and lower. And, as the market in general goes down, the mix of shares making up any given index may shift dramatically. This sets up a scenario where the fund needs to buy and sell in large volumes and not as efficiently as they would normally. And, as the value of the fund’s shares fall there is likely to be panic among novice investors who have never seen a real crash. The end result could be a race to the bottom in share prices of the ETFs and the market!
Active Investors “Police the Market” While Passive Investors Are Along for the Ride
The eventual price of any stock is determined by its intrinsic value. It is the pool of active investors and especially the investing professionals who use fundamental analysis to determine how much a stock is worth and will be worth going forward. When more and more investors follow the passive route, the determination of intrinsic stock value is being done by an increasingly small portion of the market. This sets the market up for the herd effect which is all too often seen in offshore investing but increasingly affects US markets.
Is Passive Investing Worth the Risk or Not?
The responsibility of the average investor is not to his or her fund, pension plan, or other vehicle with lots of passive investors depending on his or her decisions. The responsibility of the average investor is to his own best interests. For the time being, passive investment vehicles are still doing well and, unless you have some great ideas about what else to invest in, leaving things as they are is an option.
If you worry that the market may correct more strongly or crash, it might be a good idea to diversify a little. Some time back, we wrote about how to invest without losing any money. With this approach an investor will take of portion of his stocks or ETF shares and sell. Then he or she will buy CDs at the bank, US Treasuries, AAA corporate bonds, or a handful of stocks carefully chosen to successfully ride out a market downturn.
If you are a passive investor, it is not your responsibility to worry about how passive investing affects the market as a whole. But, you need to be aware that a passive investment can be risky and take some sensible precautions.