Pitfalls of Passive Investing


Pitfalls of Passive Investing

You can’t have your cake and eat it too.

There is no such thing as a free lunch.

You can’t have it both ways.

We’ve all heard it.  By now, we are all old enough to know that we can’t get something for nothing.  Everything has a cost, a catch. If something sounds too good to be true, then it probably is.

Passive investing is no different.  Read on to find out what Indexers aren’t telling you!

Last week, I discussed why passive investing works and how it revolutionalized an industry and brought many benefits to people like you and me.

But we know that nothing in life is perfect. So while Indexing, aka Passive investing, is getting a lot of internet hype, it’s not without its flaws.

What are some of the flaws and do they impact you?

Increased Volatility

First and foremost, the most glaring flaw is higher volatility.  The ups and downs are more pronounced now that passive investing products are available.

The swings from positive returns to negative returns are increasing.  You might have heard that the measure of volatility (VIX) has been very low until recently.  That is true.  But when there is turbulence, the movements have been large.

As more and more investing becomes automated, no one is at the wheel, there will be reinforcing actions.  What I mean is that people have built in triggers into their automated trading programs.  These programs are cheaper to employ than humans.

Example: Trigger events

The trigger might say, if the market falls by X, sell Y amount. And if that trigger is initiated, this very large fund sells Y amount. But that amount actually pushes the market down even more.  Then another X trigger is initiated and another Y amount is sold.  Imagine this happening with all the various programs out there.

There is no person at the wheel trying to swerve when downturns come around. So it may lead to market swings that some find hard to swallow.

Affecting Market Stability

Market stability is closely tied to this volatility.  Because passive investment products represent the whole basket, it has become much easier and cheaper for investors, both retail and professionals, to express their views through it.

This is because you can take action with just 1 trade.  Traditionally, you might have held 30 different stocks to represent 1 market.  So to sell it, you’d have to do 30 trades.  Each trade having a commission.  It adds up!  But now, it can all be done with just 1 trade and 1 commission.

Example: Brexit

Take the day after Brexit. Many of us in North America woke up to this surprising result.  Many people then think, ok, how can I use this to my advantage to 1) not lose money or 2) make money?

Many people got into the office and sold their European shares.  But some people did more than that.  They got into their office, sold their European shares (if they had any) and then short sold even more.  They were betting on the market to go down and when you short sell, that means you sell something you don’t own at the current price and you buy it back later when the price is lower.

For the first several hours after the Brexit referendum, the European passive investments were down much more than the general stock market.

When companies like Black Rock get an order and there aren’t enough shares to fulfill that order, they go out into the market and create more.  They do this by actually buying or selling the shares of the companies representing the market.  So if there were sustained demand from 1 side, the market then starts to get influenced by the product, instead of the product following the market.

Higher Correlations

There have been academic studies showing that the correlation of individual stocks against the market basket has been increasing.

We know that we are supposed to “diversify”.  It’s explained to us that buying a single stock is risky because we have all our eggs in 1 basket.  So we go out and buy more eggs and put them in different baskets.

However, it’s been shown that more and more, the movement of individual stocks are now mirroring the whole basket and vice versa.  So we are losing some of those diversification benefits that we had hoped to achieve by staying out of single stocks.

Passive Investing = Passive Governance

As I write this in 2019, our society is paying more and more attention to the governance of all companies.  Are they doing the right things; paying a fair wage, respecting individual rights?  What’s more, we are looking at issues like how is the company impacting the environment?  How are they contributing to the socio-economic inequity we see around us?

These things are mainly influenced at a very high level through the Board of Directors.  But the Board of directors actually works for the people who own shares of the company.  It’s up to investors, the owners, to tell the Board of Directors how they want their business to be run.

Each share of stock usually has a vote attached.  Most people get them through a “proxy”.  The Proxy is a ballot of how you vote on certain decisions the owners get to make on the running of the business.  From how much the CEO makes to who stays in the Board and who gets voted out.

However, with more and more people choosing to buy Index funds and passive ETFs,  we no longer have these votes.  The votes actually belong to the companies creating the funds.  So the Vanguards and the Blackrocks.  The problem is, are they reviewing these proxies and voting them the way that our society wants them to?

Example Blackrock

Blackrock has over 6.5 Trillion dollars under management.  Vanguard has 5.3 Trillion.   The US market is valued at 30 Trillion.  So that means, these 2 companies hold 1/3 of all of the shares in the United States!  That’s a lot of influence!  Yet, Blackrock only has 25 people worldwide working on proxies! (source: Alan Green) They rely on third-party governance services like Glass Lewis for recommendations.  When was the last time you made your views known to Glass Lewis?


Exactly. I wouldn’t even know how.

Perils of Passive Investing

As we saw last week, there are a lot of tangible benefits of passive investing.  But this week, we are now seeing there are philosophical drawbacks of it too.  How do we stomach the volatility in our portfolios? What steps might we need to take to increase diversification if we are not getting it with the basket versus a single stock?

On a broader societal level, how do we make sure that regulators have a handle on market stability when there are these feedback loops?  How can we ensure that as shareowners in a company, we get to have our opinions reflected in the operations of that company?  How do we, as shareholders, affect change on these companies?  How can we democratize investing so that everyone can benefit?

I believe passive investing has been a net benefit for most of us.  But as we get ourselves in better financial footing, we are empowered to use this footing to help others.  We have long known that money = power, so how do we use ours for good?

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