The fatal flaw passive investments suffer from
While growing in popularity as a cheaper and easier option, taken at the macro level the form of investment undermines supply and demand – not a good thing
Turn to the personal finance pages of pretty much any newspaper or magazine, and the chances are you will find at least one article extolling the virtues of passively managed investments. Unlike traditional active managers, who attempt to seek out the stocks that offer the best value or the most attractive earnings growth, passive managers simply try to replicate the performance of a benchmark index.
Passive management is a lot easier than its active cousin. Passive managers don’t need to wear out shoe leather visiting companies and talking to corporate managers. They don’t need to sweat over spreadsheets to estimate future returns on capital. They don’t need to understand the risks and rewards of different business sectors. In fact they don’t even need to hold all the stocks in their benchmark index. All they have to do is buy an optimisation programme that allows them to track the index’s performance within an acceptable margin of error.
Unsurprisingly, this means that passive management is a lot cheaper than active investment. Actively run funds typically charge an annual fee of 2 per cent of assets under management; passive funds can get by happily on 0.5 per cent or less.
That differential has a big impact on fund performance, especially as it compounds over time. Last year in the United States, fewer than a third of active managers succeeded in beating their benchmark. Over the last 10 years that proportion falls to less than 10 per cent.
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It is little surprise, therefore, that investors are voting with their feet and abandoning actively managed investment funds for passive index funds. As of last year, passive managers had captured roughly a third of the US mutual-fund market. And with assets at passive managers growing at close to 20 per cent a year, while actively managed funds are stagnant, that proportion is only set to grow in the coming years.
That is going to be an enormous problem. Because although the argument in favour of passive investment sounds reasonable, in fact it is based on a major fallacy.
This is what logicians call the fallacy of composition: that an action which is perfectly rational at the micro level of the individual can lead to catastrophe on a macro level. The classic example is a bank run. It may make sense for an individual to take his cash out of a bank if he is worried the bank might fail. But if all the depositors withdraw their money, they precipitate the very failure that they feared.
To see how this applies to passive investment management, consider what would happen if all investors, or at least a sizable majority, opted for passive rather than active managers. If they did, it would mean the stock market would no longer be performing its most important function: that of a price discovery mechanism for capital.
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Active managers buy stocks based on their assessment of companies’ abilities to generate high returns on capital. As the price of those shares goes up, the companies get access to more competitively priced capital. In contrast, companies with poor returns cannot access capital, and they go out of business. This is the process of creative destruction which powers economic growth and improvements in our standard of living.
But passive managers care nothing for returns on capital. All they are concerned about is a company’s market capitalisation, which is determined by the price and number of its shares, not by the returns it generates. After all, the passive manager’s benchmark index is made up of the companies with the biggest capitalisation. And the bigger their capitalisation, the greater their weight in the index, and the more of their stock passive managers have to own.
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Think for a moment about the implications of this. Basic economics teaches that the more the price of something goes up, the less demand there should be for it. But in a stock market dominated by passive managers, the more a stock’s price goes up, the more demand there is for it.
In short, the price discovery mechanism will no longer work. The companies with the biggest weight in the index will be allocated the most capital most cheaply, regardless of their ability to generate returns. As a result, their capitalisation will grow even as their returns decline. The result will be the end of creative destruction, stagnation in economic innovation and sinking rates of economic growth.
There are arguments that this is already beginning to happen today, as more and more assets flow into passively managed investment funds. So reflect when next you come across a story extolling their merits. While passive funds might appear to make sense for individual investors, in the long run the consequence of their growing popularity will be poverty for all. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years
