Passive Investing Is Dumb and Unethical…Or Is It?

Despite what many would like to believe, the active vs. passive debate is very much alive and kicking.

In fact, it has never been so relevant. One just needs to look at flows, performance, and regulatory agendas. All seem to lean toward the passive camp, while active managers are trying to find ways to keep their jobs.

Today, passive funds, including traditional index funds and exchange-traded funds, or ETFs, which track market indexes like the S&P 500, represent almost a quarter of total fund assets globally, according to Morningstar data. They enjoy an even higher market share in the US: a full 36%.

The reasons for the popularity of passives, and ETFs in particular, are widely known. They are cheap, offer diversified access to virtually all asset classes, and outperform active managers on average over the long term.

Yet critics bluntly argue that passive funds are, at best, dumb and, at worst, unethical.

Why “Dumb”?

Market-capitalization-weighted indices are full of flaws. For starters, they buy securities that have gone up in price and sell those that have been beaten down. This is the opposite of what a disciplined portfolio manager would do, as she would typically reduce her allocation to the assets that have gone up the most in value to buy more of those that haven’t; this brings things back in line with her targeted portfolio asset allocation.

As a result, market-cap indices are prone to concentration and market bubbles. For instance, during the dot-com boom of the late 1990s, the S&P 500 Index had large exposures to technology, media, and telecom (TMT) stocks, which ultimately collapsed. When the bubble finally burst, the flagship index fell by more than 40%. It took four years to return to its pre-crash value.

Another major issue with indices is that they are easy to game. Index changes are announced days or weeks prior to the rebalancing date. So hedge funds buy the new constituents, hoping to sell them to indexers later at a higher price. And they do the reverse for stock demotions.

Why “Unethical”?

By owning "the market," investors in index funds rely on other market participants to price stocks on their behalf. This, of course, raises questions about market dynamics and price discovery as passives look set to continue rising.

Passive investors are also accused of not caring about the companies in which their funds invest and of being negligent on questions of corporate governance. Some academics go as far as suggesting that index investing discourages competition among companies—for example, driving up ticket prices in the US airline industry.

A Smart Choice

All that said, indexing has proven to be a smart choice for many investors, for whom the criticism laid against passive investing doesn’t stand up to proper scrutiny.

This has been especially true in more efficient markets like US equities, where it has become increasingly difficult to beat the market after cost. With technological advances, everyone has access to the roughly same information at roughly the same time. Meanwhile, the number of professional investors has increased—as evidenced by the explosion in the number of CFA charterholders—making it harder for anyone to have an edge.

In addition to low fees, index funds following a market-cap strategy benefit from low transaction costs. This is because the index is effectively self-balancing. Transactions are limited to adding or removing firms from the index. As the arithmetic of investment informs us, the less an investor spends, the more he keeps, in the form of additional assets that can further compound in the future.

Meanwhile, on the issue of ownership responsibilities, the argument in favor of passive funds is that they are long-term shareholders—they have no choice but to hold every stock in a given index. And as such, they have every reason to make sure that all companies in the index do well, irrespective of industry. This contrasts with active funds, which can simply sell a stock when they disagree with the way a company is run.

The good news also is that, with the rise of indexing, passive fund groups are under growing pressure from investors to prove they are adequately policing the companies they invest in. BlackRock, Vanguard, and State Street have recently beefed up their corporate governance teams and seem committed to working more closely with companies on prominent issues like executive pay, board diversity, and climate change.

Taken together, all of this means that passive does have a place in the universe of investing. While it’s not right for everyone, all the time, what strategy is?

About the Author

Hortense Bioy, CFA heads up the passive fund research team at Morningstar in Europe. She describes herself as a CFA globe trotter as she completed all three levels of the program in three different cities around the world. Prior to joining Morningstar in 2010, she worked for Bloomberg as a financial journalist. She began her career as an M&A analyst at Société Générale in Hong Kong, after obtaining a Master’s Degree in Finance from Paris Sorbonne University.