ETFs: the road to serfdom?

Are you a budding revolutionary, looking to undermine capitalism from within? Then buy cheap trackers and exchange-traded funds, and wait for the rapid growth of passive investing to do the rest. That's according to a new paper called The Silent Road to Serfdom: Why Passive Investing is Worse than Marxism by Inigo Fraser-Jenkins and analysts at US research firm Sanford C Bernstein.

In essence, the report defends the social contribution of active managers. The point of capital markets is to allocate resources efficiently. Good companies should attract investment, while bad ones fail. Fraser-Jenkins argues that active managers, poring over fundamentals to find undervalued businesses and sell overvalued ones, are key to this process. Passive investing, by contrast, is backward-looking money chases money, with no regard to quality. In a 100% passive market, notes Bloomberg's Matt Levine, "the biggest company... today will remain the biggest... tomorrow, and capital will never be allocated from bad uses to good ones". That, says Fraser-Jenkins, is worse than Marxism central-planning may be inefficient, but at least it's a conscious process. Passive investing merely leads to momentum-driven short-termism.

There's some logic to this if money blindly chases only the biggest stocks, then you have a market driven entirely by momentum, not fundamentals. But when it comes to practical points for investors, it's worth remembering that even if there is such a thing as "too much" passive investing, we're a long way from that point. Roughly a third of global assets are now run passively, against a quarter five years ago. And that includes "passive" investments with more selective criteria, such as "smart beta" funds (see below) many of which are constructed based on the same fundamentals active investors claim to monitor, rather than purely on market cap.

At MoneyWeek, we are not against active investing, but the fact remains that most active funds fail to beat their underlying index after costs. So it makes sense to view passive as a default option, unless there are good reasons to pay up for an active manager. As for fears that passive will ever take over, that seems unlikely, as economist Burton Malkiel tells Barry Ritholtz: "If in fact it was the case that markets were getting less... efficient at reflecting information... there would be a profit motive for somebody to jump in... that's the beauty of capitalism." In other words, the more investors favour passive over active, the more pressure there will be on active managers to prove their worth. Eventually, the only survivors will be those who can offer genuine outperformance good news for us all.

I wish I knew what smart beta was, but I'm too embarrassed to ask

As passive investing has soared in popularity, the idea of "smart beta" has come along to tackle this objection. Smart beta is the term for a range of strategies that aim to beat the market by investing in certain types of securities that seem persistently to outperform over the long run. For example, research suggests that stocks with low valuations tend to outperform those with high ones ("value" investing).

A smart-beta strategy is still passive it uses a set of rules, rather than human discretion, to identify stocks that meet certain criteria and then invests in all of them, which should keep costs lower than with a typical actively managed fund. For example, a simple dividend-based smart-beta strategy might be to buy the 25 FTSE 100 stocks with the highest yields. The criteria used are often referred to as "factors", and so smart beta is also known as "factor investing".

Like every other financial innovation, smart beta is at least partly a marketing ploy, so always ensure you understand the underlying product before you even consider investing.