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What Passive Investing Does Not Teach You

Recently I have been thinking a lot about passive investing. Passive investing has been in the news over the past few weeks after Dr. Michael Burry came out to declare that he believed the passive investing market is in a bubble.

Following this declaration, investors and analysts across Twitter have been comparing their views and numbers on the topic.

The discussion took a new turn when it emerged that the value of assets invested in passive funds has surpassed the value of assets in actively managed investment funds for the first time in the U.S.


It is difficult to tell what this means for equity investors and market structure in general. Some analysts and investors have claimed that the rush towards passive investing has distorted market valuations. Others have claimed that the boom in passive investing has had no impact on the market. They state that because hedge funds and active managers still do the majority of trading and price discovery, markets still function effectively.

No certainty

We don't know at this point what the long-term impact the boom in passive investing will have on the market. However, one thing that is clear right now is that the valuations of certain stocks with large passive ownerships have risen substantially above long-term averages.

It is difficult to tell if this is a result of the passive investing boom or is just a side effect of the 10-year-long bull market.

Booming demand

There's no getting away from the fact that the demand for passive investment products is booming. There's also no getting away from the fact that research shows over the long-term the average investor does far better investing in index funds compared to picking stocks.

But there's one thing that passive investing does not do, and that is protect investors from themselves.

Investing vs. speculation

Benjamin Graham's book, "The Intelligent Investor," has taught a whole generation of value investors to view stocks as ownership interest in a business, rather than just ticker symbols on screens. This is a fundamentally important part of investing, and it is something all investors should know and understand.

Is it possible to do that when you are investing in a passive tracker fund? I think it is difficult to answer this question. Most of the investors I speak to who have placed all of their funds in tracker funds or exchange-traded funds do not really care about the underlying securities. All they care about is long-term returns. This breaks the link between stocks and businesses. If you are only investing in returns, you're not investing in the businesses. It is as simple as that.

This gives rise to another possible issue. Traditionally, speculators are defined as gamblers who bet on rising stock prices. Meanwhile, investors are usually defined as people who own a piece of the business because they like the prospects of the enterprise and spend more time focusing on underlying fundamentals rather than the current stock price.

Based on this simple definition, you could argue that passive investors who do not understand how the market works and are not investing in individual companies are speculators.

Time will tell

This is an ugly side of passive investing that does not receive much attention. Something both Graham and Warren Buffett (Trades, Portfolio) advocated is that to be a successful investor, you have to concentrate on the underlined businesses and ignore stock price movements.

If you are investing in an index purely because you want to achieve steady returns, you are ill-equipped to deal with market volatility. Only time will tell if the current passive boom will last through the next market downturn or if the investors who've flocked to these instruments will run away as their speculative adventure comes to an end.

Disclosure: The author owns no share mentioned.

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This article first appeared on GuruFocus.