In Focus: Passive Investing  

Happy 50th birthday, passive funds

Tim Focas

Tim Focas

Make just one investment and you own the whole market – any investor's dream, right?

There is no doubting the influence of the passive investment phenomenon on modern equity markets. It is, after all, by far the easiest way to be diversified across the entire market.

The proof of the pudding is in the eating as they say, and with over $16tn (£11.83tn) in global index funds since John McQuown and his team at Wells Fargo set up the first ever ETF five decades ago, it is fair to say numerous investors have had their slice of an increasingly large cake.  

But as with any investment, and birthday cakes, one can have too much of a good thing.

In fact, has anyone considered that, for some investors, index investing may be one of those cakes with too much icing and sprinkles, and not enough sponge?

It is easy to forget that passive investing has removed price discovery from the equity markets.

Models that push people into indices mimicking investment strategies do not require the security-level analysis that is required for true price discovery. Sound familiar? 

It should do, as this is similar the synthetic asset-backed collateralised debt obligations bubble of the late 2000s.

Price setting in mortgage-backed securities was not done by fundamental security level analysis, but by massive capital flows based on risk models that proved to be false. 

Index funds are so easy and effective that it seems every man and his dog owns shares in an FTSE 250 index because they believe it is good to hold a diversified basket of blue chip stocks that represent the market and hold them for a long time.

There is, of course, merit to this view.

However, it can also sound a lot like investors are not paying any attention to what they are actually buying.

While this works up to a point - as it is what passive investment is all about, apart from the cost argument - there are questions that have to be asked when investing in stocks just because they are in a certain index.

Think about it: “Why do you own shares in Virgin?” “Well, I don’t know, I just own an investment vehicle that tracks the FTSE and Virgin is in that index.”   

The point is that passive investing can remove price discovery from – in this case Virgin – which means there is some external force influencing the prices of the stock other than the underlying financial performance of the business.

That external influence is millions of investors all buying the index. This is exactly how bubbles form – when the underlying business performance is no longer the anchor for the true price of the stock.