Passive investing has come to play a central role in how investors allocate their capital. While active investment strategies may frequently adjust capital amongst investments, passive approaches simply buy and hold assets over long periods of time (usually for 10-20 years). Instead of rehashing the old debate of whether active or passive approaches are superior, here we will consider the tradeoffs of passive investing approaches that are so popular today. By examining these limitations, investors can shift to more appropriate financial vehicles that can achieve their financial objectives through their desired means.

Background
The fundamental basis for passive investing is the notion that markets are efficient and that it's difficult to exploit market inefficiencies over an extended period of time. In other words, efficient markets imply that it's hard to beat the market because excess returns get competed away. Because it's so hard to beat the market, investors have increasingly opted to take a passive approach to managing their capital, often seeking indexation along the way. This is commonly done through the use of index funds (ETFs or mutual funds which mirror the holdings of an index such as the S&P 500, Nasdaq 100, or Russell 2000).

Although index funds may appear to execute a passive investing strategy on the surface, they actually introduce several costs which can add up over time and at scale. If there were no costs, then companies like BlackRock, Vanguard, and State Street wouldn't be able to maintain their high profitability. In truth, they skim minor fees from lots of investors who use their financial products. In aggregate, these asset managers can turn a healthy profit and the investors are none the wiser for it.

Problem 1: Hidden Turnover
The first mistake most investors make is conflating index investing with passive investing. As stated previously, index investing is simply investing in the same assets that an index might contain. The problem with this approach is an index's selection criteria may produce significant turnover in the underlying assets of that index. While the index may still hold the same number of assets, the individual assets selected in the index may change drastically.

A significant share of index funds have significant turnover, but most investors don't notice this activity because they invest at the ETF / mutual fund level. In FY 2021, the popular QQQ ETF (which tracks the Nasdaq 100) had a 9% turnover, while the IWM ETF (Russell 2000) had a 23% turnover. The figure is even higher for the Russell 2000 Value and Growth ETFs, at 35% and 40% annual turnovers respectively. Even a low turnover rate of 5% would leave a portfolio with only 60% of its original investment positions after 10 years of activity.

While the retail investor may remain passive in allocating capital to an index fund, the fund itself may be fairly active in its selection of portfolio assets, even when following an index. Therefore, investors who think that they are investing passively by using such index funds may not actually be getting what they want.

Problem 2: Over-Diversification
Many funds carry hundreds (or even thousands) of portfolio investments, but financial theory shows that the benefits of diversification are generally lost beyond 20-30 unique investments. Investors should not conflate diversification with passive investing, and they should evaluate the long-term growth risks of over-diversification. The primary risk involved with such an approach is that not everything in an index fund may be worth investing in.

In theory, we may assume that asset prices appreciate in the long-run and exhibit weak, random correlations with one another. Because of these low correlations and positive returns, different assets may offset one another to produce an aggregated portfolio that performs better than any of the individual components. Therefore, adding new assets to a portfolio may reduce risk without reducing returns; this is the great benefit of diversification.

But in practice, investors have a limited universe of assets to select from and stock returns are tend to be highly correlated (especially in times of crisis). Furthermore, stock returns tend to be highly skewed; only a handful of assets will deliver the majority of the returns over the long-run. This behavior is often referred to as a power law, and it is embodied by the fact that the largest companies in the stock market are disproportionately larger than the rest. Over the past 40 years, the top 1% of companies in the S&P 500 have generally accounted for 10-20% of the total market cap of the index.

Because returns are generally correlated and highly skewed, over-diversification can marginally decrease return-to-risk with the introduction of new assets to a portfolio. Investors should not confuse passive investing with lazy over-diversification. A passive investing strategy can also be concentrated in a select number of assets, perhaps increasing long-term returns. Investors may also want to consider style, sector or size factors when selecting assets for passive strategies.

Problem 3: Management Costs
Many passive investors fail to consider the cost of their chosen investment vehicles. Although ETF management fees have fallen sharply over time, mutual funds and pension funds still incur average annual fees of 1-2%. These figures can add up to significant amounts for over long periods of time. For instance, a 1% annual fee would cost a cumulative total of nearly $79,127 over 20 years (starting with $100,000 and earning an 8% annual return). Investors should pay attention to these costs, particularly in the context of a fund's historical performance. Investors should avoid passive index funds which impose significant management fees.

Furthermore, many investors don't take advantage of yield-enhancing tactics like selling covered calls, lending their shares, or monetizing their shareholder votes. Layering these enhancements on top of one's passive portfolio may generate supplemental income, particularly during turbulent or volatile markets. Investors can take advantage of these methods without needing to actively manage their equity positions.

Problem 4: The Lack of Voting Rights
Finally, almost all investors end up forgetting about their shareholder voting rights because of the complacent psychology that comes with passive investing. Just because investors are passive in their asset allocation does not mean they have to be passive in corporate citizenship. Smart passive investors may actually sell their voting rights to create additional income and beat traditional passive investing strategies. Virtually no ETFs in the U.S. currently enable investors to vote their shares, giving ETF providers control over voting rights as the intermediaries who own the underlying equities. This stands in sharp contrast to mutual funds, which have granted pass-through proxy voting to their beneficial investors for years now.

The result of disenfranchising investors is that financial intermediaries have garnered significant power in corporate governance. Asset managers like BlackRock, Fidelity, Vanguard and State Street manage combined assets of over $23T. While these intermediaries do not actually have much direct exposure in their holdings, they do retain valuable voting power which influences public companies across the board.

Although some progress is being made to provide pass-through proxy voting, investors can avoid these deficiencies altogether by manually selecting assets rather than using index funds. When an investor directly holds equities in their brokerage account, they are entitled to shareholder voting rights, which they can exercise or monetize.

Conclusion
While passive investing remains a viable strategy for most investors, it carries meaningful costs which can accumulate over time and at scale. Small management fees and the lack of voting rights grant significant power and authority to financial intermediaries, who ultimately are not the beneficial shareholders.