Sensible Perspectives

Is Passive Investing Bad for the Economy?

Posted by on November 29, 2016

In August, Inigo Fraser-Jenkins of Sanford Bernstein published “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.” Since the note was for AllianceBernstein clients only, I can’t quote from it. I can’t even read it! The comments that follow are necessarily second hand, based on the responses[1] of several commentators who somehow got a copy.

Let me start by saying that Sensible Financial® has been advising clients to invest using passively managed mutual funds since we started in 2002. That’s nearly 15 years of advisory experience, and many client years of investment experience. In brief, I confess to coming to the argument with a point of view.

As you probably know, AllianceBernstein is an investment management and research firm. According to their website, they manage $490B. They actively manage mutual funds and institutional (pension fund and endowment) assets. They earn their living by providing investment insight and investment results. AllianceBernstein also comes with a point of view.

As I understand it, their argument boils down to this: because passive investors don’t consider the pros and cons of individual securities in their portfolios, they don’t actively choose among the securities available in the market. If all investors were passive, no investor would compare individual securities to each other. The capital markets would cease to be dynamic allocators of capital, and our economy would stagnate.

How capital markets work

Capital markets bring together investors or providers of capital and corporations and public entities who need capital. Those who need capital compete with each other to offer streams of investment returns that will be attractive to investors. Investors compete with each other to offer capital on attractive terms. The competitive capital market produces market prices for capital – interest rates (for bonds) and rates of return (for stocks) which vary depending on credit risk and the length of the loan (for bonds) and on risk of investment return (for stocks).[2]

The capital market is dynamic – new information is constantly arriving about the availability of capital from investors and their willingness to accept risk, and about the distribution of future investment returns and risks, both in the aggregate and at the issuer level. As the information arrives, market prices for capital change, and so do prices of individual securities. Prices of stocks with projected returns that have diminished or become riskier decline, and prices of stocks with improved prospects increase. Bonds with more attractive prospects also rise in price (their interest rates fall).

This works well for the economy as a whole – the companies with the best opportunities, as assessed by investors, get the most capital. The investors who make the most accurate forecasts about which investment opportunities actually will work out best earn superior returns.

Passive investing works for most investors

For individual investors, the single most valuable insight of Nobel prize-winning financial economists Markowitz, Sharpe, and Fama and of other serious students of financial markets has been that passive investing works well. Simply buying an index mutual fund generally reduces investment costs dramatically, and performance after fees  is usually better than one might obtain in an actively managed mutual fund. Let’s (very roughly) quantify those benefits. There were $4T in index fund assets at the end of 2015 according to Business Insider.[3] If we estimate (conservatively) that investors save .5% or 50 basis point in fees by moving from an actively managed fund to an index fund, that adds up to $20B per year in savings.

In addition, passively managed mutual funds very frequently outperform actively managed mutual funds.[4] The investor in such funds thus is likely to pay less and receive higher returns net of fees. And, because passive funds trade less, they realize fewer capital gains. Passive investors tend to pay less in taxes as well.

The fact that passive investors receive better returns implies that so far, at least, most passive investors have been more successful at allocating capital than most active investors! They are selecting a mix of securities that perform better. If anything, then, the amount of passive investing we have with the amount of active investing we have is better for the economy than all active investors would be.

But, if all investors were passive…

So far, passive investing works as expected. Passive individual investors are saving money and earning better returns, and the economy is working better because there are fewer bad investment decisions.

Largely due to this experience, more investors are moving to the passive approach. There are fewer active investors every day. If this trend continues, eventually all investors will be passive.

But what about the AllianceBernstein argument that if all investors were passive, no investor would make judgments about individual securities? It’s difficult to disagree that capital allocation would suffer if all investors were passive.

However, I have two objections to the key linchpin in the argument: eventually all investors will be passive.

First, even today’s passive investors are not truly passive. Most “index” funds invest in only part of the market – industry sectors (technology, health care, etc.), “smart beta,” countries (Israel, Thailand, China). Many passive investors are making comparative judgments about parts of the market, and those judgments effectively turn out to be about individual stocks.

Second, suppose that all investors were passive, and that capital was being (badly) misallocated. This would mean that some stocks would be overpriced (their expected returns would not justify their high prices), and others underpriced (their expected returns would be a bargain at their low prices). It is impossible to imagine that no investor would notice the opportunity to make money by selling the overpriced stocks and buying the underpriced ones.

There is no shortage of investors who want to make more profit than the market offers.[5] Investors would move from passive to active so long as capital was being poorly allocated (companies with poor prospects receiving more capital than companies with good prospects).

I can agree with Fraser-Jenkins and AllianceBernstein that if all investors were passive, there would be negative repercussions for the economy. However, I can’t imagine that all investors ever would be passive. I’m not worried that we’ll get too much passive investing. If I’m worried at all, it’s that too many individual investors in active mutual funds are earning lower returns than they could if they just moved to passive fund investing.

 

[1] Swedroe, Larry, “Passive Investing Won’t Break Market;” Kawa, Luke, “Bernstein: Passive Investing Is Worse for Society Than Marxism;” Goodman, Beverly, “Is Passive Investing Really Worse Than Marxism?.”  Burton G. Murkiel recently made an argument similar to the one I make here in “Is Indexing Worse Than Marxism,” in the Wall Street Journal.

[2] This is a vastly simplified summary of the risks inherent in capital markets.

[3] Udland, Myles, “The incredible rise of the $4 trillion equity index fund business in 1 chart”

[4] S&P Dow Jones Indices compiles data on this question every six months. The latest iteration is “SPIVA® U.S. Mid-Year 2016.”

[5] For two fascinating book-length demonstrations, see Flash Boys and The Big Short, both by Michael Lewis.