One of the biggest debates among investors is the question of active investing versus passive investing. Most people have strong opinions on the topic, and they are passionate about the merits of their preferred method of building wealth.
As the name suggests, active investing is a hands-on approach to portfolio management. Those who prefer this method constantly analyze the market, examine and predict the future trajectory of any given asset.
They trade more frequently in an effort to maximize gains on changes in market conditions, and the goal is to beat overall market returns by profiting from price fluctuations.
Passive investors, on the other hand, are fully hands-off. Secure in the knowledge that financial markets have always generated returns over the long-term, they park their investments in broad spectrum assets like index funds.
They ignore the regular ups and downs of the stock market, preferring instead to take a long view. Trading activity is minimal, and when they do trade, they are generally buying additional shares to grow existing positions.
One of the arguments against a passive investment strategy is that there is an expanding bubble that could burst at any moment. Investors who rely on a passive investment approach want to know, does a passive investing bubble exist?
Is There a Passive Investing Bubble?
The concept of a passive investing bubble gained traction in 2019 as more and more investors started buying into index funds.
After all, less work, lower fees, and average returns are an appealing mix for many, so investors moved large amounts of wealth from actively managed funds to passive alternatives.
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This presents something of an existential threat to active fund managers – the same folks who are opposed to the passive investment strategy. This group tends to be most vocal about the potential for a passive investing bubble, so their contributions to the discussion must be considered in context.
One of most outspoken proponents of the passive investment bubble theory is hedge fund manager Michael Burry.
In general, Burry has been quite successful in forecasting market bubbles. He made a fortune short-selling when he predicted the subprime mortgage crisis.
In fact, the story of his masterful prediction of and profiting from the subprime mortgage crisis made it to the big screen, where he was portrayed by Christian Bale in The Big Short.
The argument is essentially this:
In 2009, active funds managed approximately three times more assets than passive funds.
In 2019, assets managed in passive funds surpassed those in active funds, topping $4.2 trillion. This dramatically reduces the number of investors examining the pricing of individual assets.
Active investors look into individual companies, commodities, and industries deeply, analyzing a variety of factors to determine whether prices are appropriate.
More simply put, they examine where supply and demand meet, and in many cases, they generate profits by purchasing assets that are undervalued. When the market catches up, they profit.
Without true price discovery, Burry says:
|“This is very much like the bubble in synthetic asset-backed CDOs before the great financial crisis in that price-setting in that market was not done by fundamental security-level analysis, but by massive capital flows.”|
In other words, passive investing relies on others doing the hard work of price discovery, and if too many investors choose the so-called “free ride” that comes with low-fee passive investing, theoretically assets could be priced inaccurately.
However, Burry’s bubble prediction misses an important point. With fewer people engaged in price discovery, the rewards of identifying undervalued assets increases. That means plenty of people will continue to engage in the hard work of analyzing individual securities, and they will enjoy large profits as a result.
Does that make index investing a bubble? No. It simply means that well-managed index funds – that is to say, those with appropriate liquidity – will do just what they are supposed to do: track the underlying indexes while active investors take the risks and rewards that come with greater involvement in trading.
Few Investors Beat The Major Market Indexes
Passive investing has a lot of advantages, particularly for those who can’t devote huge amounts of time to market analysis and timing trades. The most obvious plus is that it is nearly impossible to predict market movement with any sort of accuracy.
Some investors are better at forecasting than others, and a few superstars get it right more often than not. However, superstars like Warren Buffett, John Templeton, George Soros, and Carl Icahn are the exception rather than the rule.
A majority of those who choose active investing have a strong year or two, but they are unable to consistently beat the market over time. In fact, as of June 30, 2019, 78.5% of large-cap funds underperformed the S&P 500 over the preceding five-year period.
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Why Passive Investing Makes Sense
Passive investing typically relies on baskets of assets that represent the larger market.
One of the most popular ways to achieve the necessary exposure is through index funds. These sorts of funds benefit passive investors, because their portfolios are diversified automatically.
That saves time by eliminating the need for researching and choosing specific equities to balance portfolios, while still achieving the goal of spreading investments over a diverse mix of companies, industries, and regions.
For many investors, one of the most important advantages of passive investing is related to tax liability. A strategy centered around buying and holding shares doesn’t generally result in large capital gains, which means limited capital gains taxes.
Finally, the biggest benefit to passive investing may very well be the low fees, expenses, and commissions. Because, by definition, index funds don’t require a lot of active management, the amount you pay to participate is minimal.
When added to the savings realized from limited trades, the reduction in fees, expenses, and commissions can have a substantial impact on total returns.
Of course, as with any investment, there are drawbacks and risks. The biggest issue with passive investing is that if the market crashes, your portfolio will take a hit.
However, trusting the process and leaving your portfolio alone to ride out the downturn and eventual recovery is likely to be successful.
Better yet, you have the opportunity to purchase shares at a lower-than-average price during downturns, which means greater profits in the long-term.
How To Get Started Passive Investing
Getting started with passive investing is simple, especially now that low-fee and no-fee online brokerages are widely available. These platforms typically offer digital account setup, along with a suite of automated tools that support you in making the right investment decisions to meet your financial goals.
Betterment is a leading name in self-directed investing, because it is designed with a focus on user experience.
New investors register and answer a few questions about their current financial situation, as well as short-term and long-term goals, and the technology builds out a customized recommendation that considers risk tolerance, asset balance, diversification, and financial objectives.
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The platform develops detailed recommendations for when and how much to invest, and it automates basic tasks like rebalancing, reinvesting dividends, and tax loss harvesting. However, you won’t find yourself facing large fees for these services.
Rather than charging fees on transactions, commissions, and transfers, Betterment has a flat annual fee structure of 0.25 percent of your portfolio balance. That comes out to approximately $25 per year for every $10,000 you invest.
Another popular platform, Personal Capital, is specifically designed for those who find managing their investments stressful. The technology is built to be especially user-friendly.
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For example, the Personal Capital dashboard offers a comprehensive view of all banking and investment accounts, and users can access an extensive collection of educational resources to build investment prowess.
Many users like Personal Capital for its budgeting tools. Because it brings all of your financial information together, it can analyze and illustrate what is coming in versus how much is going out. That’s an important resource when it comes to budgeting and saving, and users tend to rely on this tool to maximize the funds available for investing.
Is There A Passive Investing Bubble?
There are benefits to being an active investor. The most obvious is the possibility of outsized profits when high-risk investments are successful.
However, most investors don’t enjoy those sorts of profits – at least not consistently – which makes passive investing a smart choice in most cases.
Historically, economic markets have had plenty of ups and downs, but they have always returned a profit long-term.
Simply buying and holding funds that rely on these underlying indexes offers a more secure way to diversify portfolios, mitigate risk, and reduce fees, ultimately building wealth.
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