The Misconceptions of Passive Investing

By Grace Shi ’19

In recent years, passive funds have outperformed active managers. Actively picking stocks with the goal of beating the market is becoming a dying business, as investors default to funds that track indexes. Passive investors are not aiming to profit from short-term fluctuations in the market. Instead, they believe that achieving returns in line with the market will yield profits in the long-run.

Exchange-Trade Funds and mutual funds now offer cheaper index investing with relatively little initial research. Because passive funds simply imitate an index, they don’t need to hire as many portfolio managers. The average expense ratio of an active fund is 1.2%, while the average expense ratio of a passive fund is about half of that, at 0.67%. Since passive investing is less costly, easy to understand, and yields higher returns, many investors have abandoned active investing. Over the last year alone, investors have pulled $329 billion out of active funds and have poured $408 billion into passive funds. Only 18% of large-cap actively managed funds have outperformed the market over a 10-year period.


Many experts and investors—like Paul Merriman, a retired financial planter who started the Merriman Financial Education Center—are convinced that “most active management hurts rather than helps investors.” They are convinced that stock pickers can’t perform the role well enough for the high fees they charge. People have given up on the idea that you can get rich from being a market genius. This means active investors must prove their worth or face extinction.


Is it really the best choice to “do nothing”?


There are several arguments against the benefits of passive investing. Firstly, some critics say that past performance is not a guarantee for future profits. Investing money based on a formula replicating an index may be promising during stable times, but when downturns occur and the unexpected happens, active investing can help to hedge against serious losses.


Secondly, there is a concern about how passive funds buy stocks. An index is not the same as “the market.” Data shows that when a stock is added to the S&P 500, its price rises before passive managers buy it. Conversely, the price of the stock that’s removed from the index falls before they can sell it. This creates a drag on profits that many passive investors don’t recognize because they equate the index performance with the overall market performance. Passive investors would be giving up on the opportunity to outperform the market through well-timed active investing.


Indices are also distorted because stocks in the index become overvalued relative to stocks outside it. This means passive investors have to account for the fluctuation of overvalued sectors as they rise and fall. For now, the benefits of this distortion outweigh the costs, but the future is unclear.


Another concern is that market efficiency will decrease due to the shift from active to passive managing. If the decrease in the number of active managers is significant, stock analyses will dwindle. Eventually, stocks may not be valued correctly, as investors’ perceptions—including overreacting to recent news or an irrational reliance on intuition and emotion—will come to the forefront as hard numbers are overlooked. Stock prices may no longer be a good representation of the value of their corresponding companies, which could lead to risky investing based on incorrect information.


Some proponents of passive funds will point to Warren Buffet as an example of the virtues of index investing. Buffet’s long investment horizons and infrequent selling do reflect passive investing methods. However, in a sense, he is also an active investor because he selects undervalued companies with competitive advantages and superior management.


Ben Johnson, director of global ETF research for Morningstar has said that “the debate between active and passive is based on a false premise,” and that “the world is…not black and white. A mixture between passive and active investing might be a sound approach, in which passive management is used for broad market areas and active management is used for less efficient and narrower market segments.


The important point is that someone along the line has to do the analysis to choose the right stocks. If it’s not the passive investor, then it’s the economists who select the companies that end up in the indices. Then, who is to say that these indices actually reflect the market as a whole? Although being an investor means trying to be rational in an often irrational setting, relinquishing rationality is not the answer. This does not mean investors should revert back to active investing. This just means that passive investing has its risks as well, and that investors should understand that no option is always “safe.”







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Filed in: Economy

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