Deep Thoughts For Passive Investors

I came across an interesting factoid the other day:

Fans of passive investing clearly take this as validation of their preference for simply allocating their capital as the index dictates. However, I think that may be too convenient of a conclusion to derive from this. In fact, it may be looking at things backwards.

If you take a moment to think about the factors that might be behind this statistic, it starts to become far more interesting. Flows to passive funds over the past five years have been massive and accelerating while just about five years ago active funds began to lose assets, a phenomenon which has also accelerated in the years since.

Is it possible, likely even, that this dramatic outperformance of the index over active funds was driven largely by flows rather than the lack of skill of active managers or some other explanation? In other words, could it be that the popularity of passive investing explains its success more than its success explains its popularity?

Furthermore, if it is true that the performance of the index has largely been driven by flows over the past five years, rather than the collective opinion of educated active investors, then how efficient is the market truly? Is it possible that the popularity of passive investing has helped to inflate another stock market bubble?

Remember, passive investing is founded upon the idea that the markets are efficient and thus investors mirroring the index will realize the collective returns generated by the underlying businesses. But should the market become divorced from its underlying fundamentals due to the dominance of price-insensitive buying, what then should passive investors expect?

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Disclosure: Information in “The Felder Report” (TFR), including all the information on the Felder Report website, comes from independent sources believed reliable but accuracy is not ...

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