Could passive investing destroy capitalism as we know it?

Passive investments – low-cost funds that simply track the performance of an underlying index, rather than paying expensive “active” fund managers to try to beat it – have proved a great success.

Yesterday was the 40th anniversary of the launch of the first-ever fund to passively track the main US stock market, the S&P 500.

The Vanguard 500 index fund, launched by Jon C Bogle, has returned nearly 11% a year since then. Bloomberg reckons that over that time the company as a whole has saved investors $1trn – both in fees and trading costs, and by driving down prices industry-wide.

That’s a great news story for the average investor in the street.

But is there a danger that passive investing is getting too big? According to one high-profile paper just out, there is.

In fact, passive investment could undermine capitalism as we know it…

Stock up on index funds, comrades

Last week, we saw a headline-grabbing research paper from US brokerage Sanford C Bernstein, entitled The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism.

The basic argument is as follows. The point of capitalism and markets is to allow individuals to make decisions about where to invest their money for the best return. As a result, capital is allocated efficiently by people actively seeking out the best investments.

Under Marxism, this function is usually replaced by central planning, with the goal of providing everyone with what they need, rather than pursuing profit. It’s less efficient, but at least someone is trying to allocate the capital with a social goal in mind.

Under passive investing, the writers argue, no one is allocating capital efficiently. No one is making active choices based on company fundamentals. Instead, money just blindly flows into whichever companies are the biggest.

In short, you need at least some active management, otherwise you just end up with capital being misallocated all over the place.

I’ve written about this in MoneyWeek magazine this week (if you’re not a subscriber, sign up here), but there were a few other points I wanted to make here.

Let’s get something out of the way first: despite the headline-grabbing title, the author isn’t really saying passive investing is bad. It’s more a defence of active fund management – an argument that despite all the benefits of passive, active management still has a social function to play.

But it’s telling that such a defence needs to be made. You see, the basic problem here is that the success of passive investing has revealed a painful truth about the active fund management business: much of it is unnecessary, and subtracts rather than adds value.

Lots of active funds have been shown to be nothing more than expensive index trackers. And we’ve all known for years that it’s extremely hard to find an active fund manager who can consistently beat the market year in, year out.

The reality is that many fund managers and other financial industry actors are just people who stand in the middle of a flood of money and catch as many pound notes as they can – a bit like the majority of estate agents in the property market. Remove them from the equation, or automate their roles, and all you do is strip out an extra cost.

The Bernstein paper does make the good point that there are now a ridiculous number of indices out there to be tracked. “We now have the bizarre situation that there are more indices than there are large-cap stocks.”

But once again, this is because the finance industry is doing what it has always done. It has realised that investors like exchange-traded funds and index trackers, and it’s now trying to figure out ways to charge them more by building overly-complicated versions of perfectly good products that they can hawk to the unwary. That’s why it’s more important than ever to understand exactly what you’re buying, whether it claims to be “passive”, “smart beta”, or “active”.

And in any case, if it’s the destruction of capitalism and blind resource misallocation that’s worrying you, there are bigger things to worry about. Central bankers should be your primary target, not passive investors.

Central banks are pumping money into both the bond and equity markets (the Swiss central bank – frantically printing cash to hold down the Swiss franc – is apparently now the world’s eighth-largest public equity investor), without a care for whether the investments make sense at any fundamental level.

If anything is destroying faith in the capital allocation process, it’s quantitative easing and our growing confusion over the nature of money itself. That’s a huge problem – and, I suspect, a far more urgent and potentially damaging one.

A problem you don’t have to worry about

It’s possible that at some unknown point in the future, passive investing may end up being a problem for the structure of markets. I also imagine that well before that, it’ll start to become obvious that it’s a problem, and smart people will learn to exploit that issue and they’ll make money, and in doing so, solve the problem.

But in any case, as an individual investor, this is one theoretical problem that you simply don’t have to worry about.

Boiled down, sensible investing is a two-step process, and the passive v active debate plays only a very small part in that.

(Indeed, as I’ve pointed out many times before, “passive” funds are badly named – every single investment decision you make is an active decision to do something. The closest thing to genuine “passive” investing is just giving all your money to someone else to manage for you.)

Anyway – here are the two steps.

Step one: you make an active, informed decision about what you want to invest in – an individual company, the US stockmarket, index-linked gilts, biotech, Vietnamese utilities, whatever. You consider how it fits into your portfolio, your expected risk/reward pay-off, your time horizon – in short, why do you own this thing and what would make you not want to own it anymore?

Step two: you then find the cheapest, most effective way to do that. You own your portfolio in a tax-efficient wrapper like an individual savings account or a pension. You use the best-value broker (which may not be the cheapest, depending on your own preferences and needs).

And you choose the right investment vehicle. If that’s a “passive” fund (and it very often is), then so be it. If it’s an “active” fund (the odd one does outperform, and some sectors are hard to access any other way), then use that.

Don’t get me wrong. Those two steps require a lot of thinking, a good deal of research, and a fair bit of effort. Like anything else worth doing, successful investing isn’t easy.

But the processes involved are straightforward. And you shouldn’t let the obfuscatory arguments of a self-serving financial industry blind you to that.