The Biggest Risk of Passive Investing

There’s been a lot of outcry over the years about how passive investing is creating all these new risks. High fee active managers say “indexing is average” (see my response). Some other people say it’s hurting the economy (see my response). Others have even compared it to Marxism (see my LOL here). Okay, there’s a lot of hyperbole here mainly because there’s a lot of emotion surrounding a debate with huge gobs of fees up for grabs.  But are there real risks from passive investing?  While I think the risks are generally overstated I do think there’s one big risk:

• Persistent Equity Market Overvaluation

First of all, if you’ve read my work on this subject you know that the term “passive” is a misnomer (read my long diatribe on this here). In reality, anyone who deviates from global cap weighting is being active. The main difference between an index fund like the Vanguard Total Stock Index and the Fidelity Large Cap Growth fund is that the Vanguard fund tries to match the market return in a low fee manner while the Fidelity fund sells you the hope of beating the market return in exchange for a high fee. The Vanguard fund accepts that, after taxes and fees, they will underperform their benchmark index (this is true for all of us on average). But by reducing these fees and taxes they actually generate better average returns than the more active fund. So, it’s not that the Vanguard fund isn’t active, it’s that it’s active in a more efficient way.

But this does not mean there is no risk in the less active strategy. In fact, I suspect the adoption of these strategies is a big part of why we’re seeing persistently high equity market valuations. Over the last 40 years we’ve seen a persistent creep in market valuations.  Ratios like the CAPE ratio or the equity market as a percentage of aggregate financial assets show that investors are increasingly overweight equities on average. It’s very likely that index funds put pressure on valuations by implementing overly simplistic investing models that convince people to be more overweight equities than they might be comfortable.

One of the problems I’ve expressed with Modern Portfolio Theory is that it can result in an overly simplistic approach to equity allocation. Basically, people say, if you’ve got a long time horizon then you can afford to wait out the big ups and downs in stocks so you should be massively overweight equities. This is exactly right in theory, but life is always more complex than that. Our financial lives aren’t a simple “long-term”. They are more like a series of short-terms.  And so you’ve got a lot of fairly novice investors who don’t know this who are piling assets into high risk long-term instruments. This rush into equities has been happening since well before the tech bubble. It’s just that the boomers have learned this lesson the hard way after two market crashes.

So, the risk today is that behaviorally unprepared investors rush into an asset class they don’t fully understand. This pushes up valuations as more of our average net worth is allocated into equities and creates the potential for an imbalance where investors own more of a long-term asset than their short-term needs are comfortable with. And when a bear market sets in it is often these investors who actually exacerbate the bear market by overreacting to what is a naturally uncertain environment as they realize that what they thought was a safe diversified strategy is often just a highly stock market correlated way of allocating assets.

I’m a huge advocate of low fee indexing.  I’ve defended the indexing revolution ardently on this website. But the risk of more volatile equity markets is something I think we’ve started to see in the last few decades and something that could become even more exaggerated in the coming decades.  Thanks in large part to the overly simplistic manner in which we allocate our savings to the equity markets via “passive” indexing strategies.