But I do wonder about how markets will look in future if passive investing gains further popularity. It should create opportunities for the few diligent active investors that remain.
Today, active investing still retains some sway and most of us make many investing decisions each year. Some of those decisions are ludicrous, but our individual foibles and kinks tend to cancel out at the collective. I’m no fan of the efficient market hypothesis. But markets are quite efficient most of the time. It’s a wisdom of the crowd effect. But a precondition to that wisdom is each of us thinking and placing our individual bets accordingly.
The folly of the crowd?
Indexing skips that. We instead accept the benchmark return and minimise frictional costs in order to make the most of that return. We’re not trying to beat the freight train. Rather, we’re buying the cheapest ticket available and jumping on board. It makes immense sense at the individual level.
It worked very well when passive investing was a small subset of the total market. But passive investing is rapidly becoming an elephant, and the wisdom of the crowd effect is getting blunted in the process. Indexing could be individually smart and collectively stupid.
Of course, I’m not the first to notice this. Horizon Kinetics is an insightful source for analysis of distortions caused by indexing. Such distortions have already been offering plenty of opportunity for quick-footed active investors. Those opportunities should grow if the market becomes more passive.
Recent Wall Street Journal article The Dying Business of Picking Stocks is quite interesting in this context. It’s subscription access only. But the relevant point is that it’s not just individual choice driving investors to indexing anymore.
Managers of pension funds and other sensitive pools of capital – anyone you might see associated with terms like ‘fiduciary responsibility’ – are under extreme pressure to go passive. According to the lore of the land, the battle between active and passive management is long over, passive won.
And, because this is America, lawyers are already getting involved. Plantiff’s lawyers are increasingly bringing actions against companies and universities “contending the employers breached their fiduciary duty by allowing unreasonably high fees in their 401(k)-style plans”.
So, the shift from active to passive investing is likely to continue for a while yet. Those committed to hunting for inefficiencies in the market are salivating at the prospect. R.I.P. stock picking!
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