The idea that there’s a bubble in passive investment is nonsense

"There's a bubble in passive investing."

It's an argument that I'm hearing a lot these days. And at first sight, it sounds compelling.

You need only look at a chart of passive fund inflows to see that the amount of money flooding into such funds is huge.

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In 2012, according to consultancy Greenwich Associates, 79% of institutional money was allocated to active strategies, the FT reports. By 2015, it had fallen to 67%.

Credit rating agency Moody's reckons that the passive market will become bigger than the active market in the US by 2024.

And research group Morningstar reports that passive funds saw their assets under management rise by 18% last year, compared to just 4% for active funds.

Rapid growth. Lots of media coverage. A compelling story. No wonder people are calling it a bubble.

There's just one problem with the idea.

It's total nonsense.

Passive investing is a technology, not an asset class

Let me take a quick step back here, so we all know what we're talking about. "Active" funds employ a human fund manager to pick and choose stocks (or bonds or whatever), with the aim of beating the market. "Passive" funds use a computer program to simply copy the market. You have no chance of beating the market but you also don't pay a high fee to the human fund manager.

Now, obviously we'd all like to beat the market. But history and countless studies show that most active managers can't actually do it. So a lot of the time, you're paying them over the odds for underachieving. Hence the rising popularity of passive funds.

The idea that passive investing is a "bubble" has arisen from the fact that they've become very popular and we're seeing more and more such funds popping up to take advantage of that fact.

But it's also arisen from the fact that active managers and the traditional investment industry feel horribly threatened by passive investing, because it is demonstrating quite brutally just how badly they've been doing their jobs for a very long time. And I suspect that this is why we'll hear the argument being made a lot more in the coming years.

So let's look at why it's a nonsense argument.

The main problem I have with the idea that passive investing is a "bubble" is this:"passive" investing is not an asset class. It's just a process, or even a technology.

Calling it a bubble because people are using that process to invest their money, is about as logical as saying that there's a bubble in credit cards because their use as a spending tool has increased, and that cheque books are correspondingly undervalued. Or that there's a bubble in cars, and horses are correspondingly undervalued.

Just have a quick think about it. Let's say the equity chunk of my portfolio is worth £1m (not quite there yet, but let's think big). I currently have it invested in an actively managed fund, which invests in general UK-listed stocks.

One day I read an article on passive investing. I realise that my active fund manager is pretty much tracking the FTSE All-Share index. His top ten stocks duplicate the biggest stocks in the FTSE. His "active share" (a measure of how widely a manager's portfolio differs from the underlying index) is laughable. So I take my money out of his fund, and I put it in a FTSE All-Share tracker instead.

Have I contributed to passive fund inflows? Yes. Have I contributed to active fund outflows? Yes. Is this in some way a bubble? No. I have swapped an expensive form of exposure to the FTSE All-Share for a cheap form of exposure to the FTSE All-Share. That's it.

Indeed, in effect, I've simply gone from owning one passive fund to owning a different passive fund, only I'm not being conned anymore.

There are lots of problemswith passive investment

Don't get me wrong I'm not saying that passive investment is perfect or problem-free. I'm not even saying that for a moment.

Depending on the underlying index, some passive funds exchange-traded funds (ETFs) in particular will no doubt run into liquidity problems in the future. An ETF is meant to be redeemable on demand. Yet it's also meant to track the price of an underlying index perfectly.

If there's a rush to pull money out of illiquid underlying assets (such as certain types of bond, for example), then those two promises won't be compatible. You won't always be able to get your money back at the value you'd expect.

However, this is not a problem that is limited to ETFs. This is simply what happens when you use a structure that promises perfect liquidity to invest in an illiquid market. We saw a very obvious example of this in action during the post-Brexit referendum panic, when actively-managed, open-ended commercial property funds had to bar investors from taking their money out.

I also have a lot of sympathy with the argument that there are too many "faddy" passive investments out there there are. When you see ETFs being launched to track strangely specific market sectors, for example, that's always a bit of a red flag.

Or there are the various different "factor" funds that purport to follow the latest hot strategies. So you might be investing in low-volatility stocks, or high yield stocks, or whatever happens to be the latest "anomaly" spotted by some academic.

But again, this is just the financial industry at work. This is the same process that leads fund managers to launch dotcom funds in December 1999, or China funds in 2010 they are demand-led. If passive funds are attracting money, they'll launch more passive funds and try to put as many bells and whistles on them as possible in order to charge more for them.

None of this points to a problem with "passive" investing in itself. It's just another reminder that you must always understand exactly what it is you are buying whether that's a passive FTSE tracker, a smart beta corporate bond ETF, or a an actively managed commercial property Oeic (open-ended investment company).

The active fund management industry's chickens are home to roost

There are undoubtedly issues with passive funds. You can argue that more passive money means more market inefficiencies, as money floods into the biggest stocks. You can argue that more passive money means that companies won't be held to account by shareholders. You can argue that more passive money means more performance chasing.

But you can also argue that the active fund management industry hasn't exactly distinguished itself on any of these fronts in the last few decades of dominance. They haven't held boards to account. And too many managers have favoured quiet index-hugging to taking the risks involved in genuinely active management.

At the end of the day, if you do your job like a robot, you shouldn't be surprised when one day, a robot comes along to replace you.

There is no bubble in passive management. This is just the active management industry's chickens coming home to roost.