Passive investment not a panacea
Passive investment has grown substantially in the last decade, with 2016 seeing more than 85 per cent of new asset flows ($US610 billion or $779 billion) in the US into passive vehicles, according to Bloomberg.
In Australia, passive funds under management increased 28 per cent in the 12 months to April 2017.
The cause of this growth is clear; the costs of passive investment have steadily reduced over time (with some passive investment vehicles offering annual fees of less than 0.10 per cent) while the choice of investment areas has continued to grow. These developments have seen investors take to passive investment as a low-cost way of diversifying their portfolio.
The increased accessibility of investment markets to Australian investors is unquestionably a positive development, and there is no doubting some of the fees offered on passive investment vehicles are extremely competitive.
While investment into any market carries risk, be it via active or passive methods, there are a number of unique risks associated with passive investment vehicles, that affects both passive investors and the broader market.
While it may seem obvious, investors should be conscious of the fact that passive investments are, by their very nature, passive; there is no managerial oversight or strategic approach to stock selection.
When someone invests in (or redeems) a passive investment, they are broadly buying (or selling) every stock in the index, without any consideration of the individual merits of the underlying equities.
Although holding an arbitrary collection of stocks weighted by each company's size may seem to be a comfortable notion in periods of lesser volatility or broad market strengthening, investors should be conscious that such an approach sits comfortably with them during periods of market volatility or during a severe pullback.
Of further consideration is that passive vehicles are forced to follow the particular index they track. Portfolios are often re-balanced on a quarterly basis as the weightings of the underlying securities within the index change. While the practice of buying more of a stock as it gets more expensive (or selling a stock as it becomes cheaper) defies the age-old adage of "buy low, sell high", there are also potential tax impacts for investors as high turnover may result in capital gains being realised.
The rapid growth of passive investment may also carry risks for the broader market.
As a greater weight of money invests passively, the fundamentals of market pricing begin to break down; more money continues to be allocated to all stocks equally and proportionately, with no consideration of fundamentals.
Such an outcome could not only lead to a misallocation of capital, but has the potential to cause asset bubbles and spikes of volatility.
While there are advantages in passive investing, the risks and the potential longer-term impact on markets should be kept front of mind.