Is There A Flipside To Passive Index Investing?

A majority of active funds have not been able to outperform the market, and this has prompted many experts to suggest a low-cost passive index investing strategy. Billions of dollars have flown into this strategy by way of investing in index funds. These funds track the performance of the underlying index, and since it is a passively managed, they can keep the costs low and pass on this benefit to the customer.

According to a Morningstar report, 4 trillion USD is invested in passive US equity funds, which is roughly about 13% of the total US equity assets. In 2018, the net inflows into passive US equity funds had been 208 billion USD, and during the same time investors have pulled out 202 billion USD from actively managed US equity funds. The growth of equity ETFs (a type of Index fund) is nothing short of spectacular and about 2 trillion USD is managed under them. It is still not a huge portion of the total assets, representing less than 10% of the total market capitalization.

What is more interesting is that more than 500 billion USD has flown into this category in the last three years alone. The growth of these funds is what prompts us to analyze what would happen if passive investments become the dominant investing strategy in the market. In the Indian context, index mutual funds have not caught investor’s attention. But an interesting point to note would be the exponential growth of index ETFs albeit from a tiny base.

Source: Morningstar, World Bank

Source: AMFI

If passive index investing becomes the major investment strategy in a market, it will lead to mispricing in the markets. In a world of passive funds, all the companies get rewarded the same way irrespective of their underlying performance. All companies will maintain the same size relative to each other. In an extreme scenario, this could destabilize the fundamentals of a market economy. Passive fund managers rely on active fund managers to correct mispricing in the markets and maintain market efficiency.

One of the arguments for passive index investing is it is supported by the efficient market hypothesis, according to which it is impossible to outperform the market consistently. But even the efficient market hypothesis is based on the assumption that active fund managers such as value investors, technical traders and arbitrageurs have priced the assets efficiently based on available information.

It is true that there will be market inefficiencies with any particular investment strategy dominating the market. But it would be more pronounced with an approach like Index investing which does not take into account the underlying fundamentals of the company.

Having said that, passive equity funds still hold only about 13% of US equities, and if we take into account the trading volume, the proportion of passive assets is even considerably lesser. There is no near term threat of mispricing and inefficiencies due to passive investing, and even if we do reach a such a stage, the expectation is that active investors would capitalize on these inefficiencies and thus outperform a passive strategy. This, in turn, would tilt the balance in favor of active funds. Until then, investors should take advantage of the low cost and diversification benefits provided by index funds.