Passive Investing

“A fundamental shift in market structure towards rules-based, passive investing over the past decade means a lot of trading is no longer based on fundamentals” and the shift could lead to a global market downturn, according to a recent article in the Financial Times.

The concern has risen to the Fed, who will address the topic at this year’s economic symposium in Jackson Hole.

Passive investments ignore fundamentals, the article says, citing the example of ETFs: “Often set up to mimic an index, ETFs have to buy more of equities rising in price, sending those stock prices even higher,” thus creating a “piling-on” effect. Passive investing, it adds, could also make markets more complex by sending mixed signals to active investors about the fair value of stocks, causing a “significant misallocation of capital.” The situation is made worse by the speed at which trading is now conducted, the article notes.

“Systemic failures, misallocation of capital and dried up liquidity could cause a bear market, dragging on growth when the economic backdrop is already lackluster,” the article concludes, warning us not to be fooled by the country’s second-quarter GPD growth of 4.1 percent. “The underlying fundamentals of the U.S. economy leave a lot to be desired. A market crash—worsened by systemic effects—would probably send the economy into a tailspin.”

The market environment of the past few years has been nearly ideal for passive investors, with strong overall returns dominated by the largest companies. But investors should not be lulled into believing that this environment will last forever. For a long-term investor, passive investing may be an important part of a portfolio — specifically in the most efficient asset classes where information is abundant and securities are generally fairly priced relative to one another, such as U.S. large cap — but we suggest that it may be best used in conjunction with active management in less efficient asset classes (including, for instance, international and emerging markets, small cap, etc.). An active investment strategy can offer significant advantages for long-term investors, and the potential higher cost is irrelevant if the net-of-fees return over time is higher.

Of course, not all active managers are alike, and thoughtful, careful manager selection can make all the difference in the success of an active investment strategy. This is where Arnerich Massena comes in. Our long-term success in selecting active investment managers is a significant differentiator in our clients’ portfolios. Let us help you avoid the pitfalls of passive investing with our world-class active manager research and selection process.

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