Thursday, May 5, 2022

Passive Investing Has Gone Too Far

I was reading on Bloomberg today when I found an article titled, "Elon Musk and Cathie Wood Say Passive Investing Has Gone Too Far" [link].

Both are well-known personalities, albeit in different arenas. I would understand why Cathie Wood, portfolio manager of the actively-managed ARK Innovation ETF, has an axe to grind against passive investing. But it is rare to see Elon Musk comment on the same topic.

Passive investing in the form of Exchange Traded Funds (ETFs) has grown over the years. According to Statista, the AUM parked under global ETFs has exceeded 10 trillion U.S. dollars in 2021 [link].

The growth has been most significant over the past two years, when COVID-19 restrictions forced people to stay home. According to a study by FINRA, more retail investors had flocked to the equity market during the pandemic [link].

I suspect the same reason also explains why there is a greater interest in cryptocurrencies and non-fungible tokens now among the general public.

The argument that active investors help to maintain accurate valuation of a listed company is one I have heard for a long time. If there is a shortage of investors who trade on the counter day in and out, the price can deviate significantly from the appraised value.

A dearth of active investors will give more clout to ETF managers. When a company is added to the index, the stock receives a huge boost in demand. Conversely, when a company is removed from the index, the stock suffers a huge selloff, as ETF managers rebalance their portfolios.

Such market-shaking price movements have nothing to do with any change in the business. This is the beef that Elon Musk has with passive investing.

Unfortunately, the siren song of ETF investing has been well ingrained into the mind of the general public. ETF AUM is set to grow, giving even more sway to ETF managers on the vested companies, including board seats.

The above phenomenon is neither good nor bad. It depends on how ETF managers exercise their power when they are in a position of influence on the company. We can only hope for ethics and good judgement.


Addendum:
CNBC wrote a more detailed piece on the same topic [here], which included a grim warning by Jack Bogle, creator of the first index fund and widely known as the father of passive investing.




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