The dangers of passive investing

Most of you who know me know that I am a big fan of investing in ETFs, for the sheer cost advantage they offer over most mutual funds and their more frequent tradeability.

I also prefer "plain vanilla" ETFs to the more complex ETFs that now dominate the new issue market.

However, with all their benefits, we must not lose sight of potential disadvantages and pit falls.

While, by now, most investors know that in the long run, investing at low cost into a whole index (passive) is beating 90% of active fund managers and is therefore a very shrewd investment strategy, the stratospheric ascend of passive indexing has reached levels that I fear will make markets sick at some point.

The core economic function of active investment is efficient capital allocation. However, it seems that a company's fundamental business prospects are now much less important than its presence (or absence from) popular indexes.

The actual facts about a company don't mean very much in a passive-investing world.

Capitalisation-weighted indices aggravate this phenomenon: money is pouring into stocks like Apple, Amazon, simply because they are big. The resulting higher prices make them bigger still, and they attract yet more money.

Let's look at the performance year to date of some of the biggest stocks in the S&P 500:

Apple: + 23%

Alphabet (Google): +9%

Microsoft: +6%

Amazon: +20%

Facebook: +25%

What about some other popular indices? The QQQ or the NDX (Nasdaq).

The five stocks above represent 42% of the NDX and 13% of the S&P 500.

That means that every time you buy an index based product, say an ETF, 

42% of your money goes into just 5 stocks, leaving 58% of your money to be invested into the remaining 95 stocks.

By the time you get past the largest 25 companies, you are under 1% of investment per stock.

This is more like the definition of a "concentrated" stock portfolio.

Apple alone is now 12% of the NDX and 4% of the S&P 500.

Indices are now more than ever dependent on a few very big stocks and the biggest, most liquid ETFs are mirroring these indexes.

When the ETFs start selling, who will buy?

I don't know the answer, but my guess is, that the prices will come down much faster and to much lower levels than any of us can, or will, imagine right now.

Just be careful out there and remember that, while low cost index investing is a very good strategy for the serious long term investor, you have to be prepared for the "bumps in the road". It's usually in times of falling markets that the active manager takes a shine.