The Passive Investing Bubble Is Real

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Includes: DIA, QQQ, SPY
by: Michael A. Gayed, CFA

Summary

There is no question that the stats back up the idea that passive strategies have more often than not beaten active ones.

Most mutual funds are in reality closet indexers that don’t take large bets.

Passive strategies aren’t dead. And neither are active. There is a cycle to everything - and the cycle for pure beta may finally have reached its end.

It's the greatest comeback since Lazarus." - Sid Waddell

They love passive investment strategies in 2017. They hated them in March 2009.

There is no question that the stats back up the idea that passive strategies have more often than not beaten active ones. The reason relates primarily to fees, whereby passive vehicles tend to be cheaper than active ones. But the discussion and referencing of these stats are misleading. Just because a mutual fund or ETF claims to be active doesn't mean it actually is. Most mutual funds are in reality closet indexers that don't take large bets. Hard to argue that those strategies are then active, so of course passive wins out.

Never mind this nuance, however. An interesting stat from Goldman Sachs Global Investment Research shows that "passive investing accounts for nearly 40% of total equity AUM, more than twice the level in 2005."

This makes sense in the context of both performance chasing and the pure beta-driven environment over the last few years. Passive, cheap ETFs (NYSEARCA:SPY) (NYSEARCA:IVV) have dominated asset flows. But the fact that so much money has run into these vehicles is likely a red flag on the style (and make no mistake that passive investing is indeed a style). There likely is going to be a juncture where, as with all investment styles, underperformance for several years occurs.

Am I saying passive is dead if indeed we are in a style bubble? No, but the love of passive at some point likely means active anomalies return in markets. Why? Because if so much money is going passive, there are fewer dollars chasing active opportunities. This in turn makes those opportunities ever more profitable and large enough in time that those who pursue strategies which track them finally begin to generate alpha. I suspect we are near this point across the entire investable landscape.

Passive strategies aren't dead. And neither are active. There is a cycle to everything, and the cycle for pure beta may finally have reached its end.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.