The cult of passive investing
I am a huge proponent of passive investing, which is why I am constantly trying to poke holes in the idea. It’s good to think critically about your investment strategy and not get too ‘invested’ in one course of action.
The whole premise of passive investing is holding no matter what. If the market goes up or down, you don’t sell – you keep piling money in for the next 30 years. This doctrine alone feels extremely cultish and almost a prerequisite for a pyramid scheme.
The idea is that you can’t predict the market, so you don’t try. You relinquish all control of your money to a few decision makers at Vanguard, BlackRock, or State Street who have enormous power due to the amount of people investing passively through them.
Doesn’t that just feel wrong?
Let’s examine whether passive investing has the makings of a Ponzi scheme.
What percentage of the market is passive investing?
You may have read figures before, but the reality is we just don’t know exactly.
Estimates range from 16% to as high as 37.8% (FT.com). That high end estimate comes from a paper by Chinco, A. and Sammon, M. (2022), and they suggest their estimate is “almost certainly too low”.
The one area where there is agreement is that more money is flowing towards passive investing than away. Since their introduction in the 1970’s, their uptake has steadily increased. Unless some catastrophe should befall it, passive investing is here to stay.
Investment Gurus have much to gain
It’s an inescapable truth that heroes of mine like JL Collins and his ‘Simple Path to Wealth’ book have much to gain from the passive investing mania. Book sales, for sure, but also the fact that his disciples are mostly pouring money into the precise investment fund he advocates (and telling them to sell no matter what). The same fund he is investing in, propping up his wealth.
This is an incredibly conspiratorial perspective. In reality, I don’t believe any one guru has enough clout to move markets in any meaningful way. But combined, guru influence on the investment zeitgeist can continue to fuel passive investing from the alleged 37.8%, to new highs.
Industry professionals have legitimate concerns
It’s not an uncommon stance for those in the industry (many are active investors) to point out flaws in passive investing.
Ariel Investments CIO Rupal Bhansali uses the triggering phrase ‘Ponzi scheme’ when pointing out that passive investing has a low entry cost, but potentially a high exit cost. If people want to exit – who do they sell to?
Similarly, famed The Big Short investor Michael Burry say’s that when the massive inflows eventually reverse, “it will be ugly.”
Michael Green’s presentation below suggests passive strategies are distorting the market’s ability to discount new flows, affecting valuations, correlations, and volatility.
Michael suggests that as passive share increases, flows, not valuations, are the key determinants of return. If money is flowing in to the market, share prices will rise. If it is flowing out, they will fall. The effect is more pronounced as passive investment in the market grows.
Passive investment managers buy with the cash coming in, no matter what. Therefore, if there is a rush to sell, cash flowing out, the exit costs may be high (as Rupal suggests above).
We should recognize that the motivation of the three individuals above, all active investors, can introduce bias to their opinion. But it does not in invalidate it.
What did the God of passive investing, Jack Bogle, think?
The huge amount of people investing passively was even a concern for Jack. He believed more corporate governance was needed to police the corporate exec’s who run the largest companies.
“A handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation.”
Jack thought passive investing could eventually account for 70-90% of the market. He believed a limit is needed to maintain the efficiency of the market. He also believed active investing will continue the thrive as “there will always […] be people looking for values, price discovery and all that kind of thing.”
It’s difficult to see passive investing taking over completely, as Jack said. Theoretically, as more people invest passively, the less efficient the market becomes. As returns from passive investment decreases, more money should flow back towards active investing.
After a lifetime of promoting passive investing, it seems silly to focus on one or two reservations Jack had about this investment strategy. But then, for most of his life, there’s no way he could have predicted passive investing would become the phenomena that it is – so why even worry about it growing too large and the effect it might have on the wider market?
What’s the verdict? Is it a Ponzi scheme?
The short answer is no, passive investing is not a Ponzi scheme. It would need to be created with malicious intent to be classified as one.
Could it grow, independent of any malicious intent, to become like a Ponzi scheme? Yes, it could grow so large as a percentage of the market that it makes them inefficient and puts power into the hands of too few people at the major investment institutions.
Even with the high-end estimates of 37.8% of the market passive investing, it still feels under the radar. If it can keep below half the market, it doesn’t feel like a problem.
We are somewhat relying on either the ignorance of people to the value in passive investing, or their arrogance in the belief that active investing will yield better returns. The alure of being with the 20% of active managers who will outperform passive investing this year is enough to tempt people away.
This keeps passive investing in the minority position and benefiting from an efficient market. I’m not scared off from passive investing, just yet!