Why Passive Investing Isn’t a Panacea

03 April 2018

3 min read

Richard A. Brink, CFA| Market Strategist—Client Group

Walt Czaicki, CFA | Senior Investment Strategist—Equities

Scott Krauthamer, CFA, CAIA| Global Head—Product Management & Strategy

The active/passive debate has been raging for years, and both approaches have merit. But there’s more to the story than meets the eye. Investors who commit too much to passive—and not enough to active—could face mounting risks.

No one disputes that passive investing plays an important role in many investors’ portfolios—especially over the past decade. Passive strategies open the door to low-cost market access. But passive’s explosive growth is creating a buildup of structural challenges, just as active investing faced structural challenges in its heyday.

Today, roughly 1,800 exchange-traded funds (ETFs) are chasing less than half that number of US stocks with a market cap over $5 billion. ETF growth doesn’t look to be slowing down, and crowding in certain stocks and market segments is likely to intensify. As investors have piled into passive spaces, specific distortions have begun to form, with the most passively held stocks becoming more volatile and more highly correlated to each other versus the broad market. And both measures seem to be intensifying.

In our view, four factors collectively magnify the risks to investors:

Crowding. Investors who follow the herd when making portfolio decisions tend to pile into certain stocks and market spaces. The following three factors make crowding worse.
Fragility. Investors in a specific market segment or trade usually expect a certain outcome. And they’ll quickly jump ship if they don’t see the results they want. Think of it as collective flight risk.
Liquidity. Crowds in a panic run for the exits, creating a liquidity crunch. If liquidity is drying up, how hard will it be to find a door? And how much will passive investors have to pay to open one?
Passive Ownership. If passive investors in an ETF want out of a crowded trade, they have to sell the entire index, regardless of individual stocks’ merits. It’s like selling the baby with the bathwater.

What Happens When Crowded Trades Break?

February’s equity market correction gave us a prime example of what happens when too many investors are pouring too much money into a passive trade that falls apart.

When the CBOE VIX—a well-known gauge of market volatility—fell to near-record lows recently, many investors took short positions in the VIX. Essentially, they were betting that volatility would stay low for a while. But the equity market stumbled, volatility surged and the VIX quadrupled in a week. Passive investments that were short the VIX were hit hard.

Crowding isn’t restricted to more exotic trades like shorting the VIX. In 2015, we saw a widespread equity sell-off in healthcare stocks driven by concern over drug pricing. And a year later, high-yield bond markets reeled after oil and gas prices plummeted. Investors who had crowded into high-yield energy bonds panicked and rushed for the exits. It was hard—and pricey—to get out.

And the risks of passive investment continue to grow. Since passive investments replicate indices, the index business is now booming. By some estimates, there are more than one million indices today (Display)—most of them equity. And we’ve seen more passive vehicles being created to buy stocks to replicate those indices.

There Are Many More Indices than Stocks in the World Today

Through December 31, 2016
Historical analysis does not guarantee future results
*Of the approximately 43,000 stocks globally, it's estimated that roughly 2,300 can be invested in broadly.
Source:Bernstein

This boom has yet to be truly tested. We’ve never seen a period with major outflows from ETFs and passive vehicles, so there’s no way to know how big the dangers are from so many overlapping passive exposures—or the negative effect such a period could have on passively held stocks.

What we do know is that there’s a lot of money in passive investments, and there are myriad indices and ETFs designed to replicate every corner of the market in every variety imaginable. With so many investors and ETFs going after a limited number of investible stocks, it poses the question: Is there such a thing as passive investing anymore?

Passive investing certainly still has a place in portfolios, just as active does. But with passive risks rising, we think focusing too much on passive and not enough on active could be a risky proposition.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

About the Authors

Richard A. Brink, CFA

Richard A. Brink is a Senior Vice President and Market Strategist in the Client Group. Previously, he served as a managing director in the Alternatives and Multi-Asset Group. Prior to that role, Brink was a senior portfolio manager in Fixed Income, and before that an investment director for fixed-income investments within the Global Retail Investments Group. Before joining AB in 2004, he was senior product manager at the Dreyfus Corporation, covering both retail and institutional fixed-income offerings. Brink was previously a senior trainer, dealing primarily with the design and delivery of product training to financial advisors and mutual fund sales representatives. He holds a BS in applied mathematics and economics from Stony Brook University, and is a CFA charterholder. Location: New York

Walt Czaicki, CFA

Walt Czaicki serves as a Senior Vice President and Senior Investment Strategist for Equities at AB. He rejoined the firm in 2015 and has been in the investment-management industry since 1986. Czaicki's roles have ranged from a fundamental equity research analyst and portfolio manager to chief investment officer. Prior to rejoining AB, he worked on the buy side for a Regions Financial predecessor organization, as well as at Commerce Trust Company and Bank of America. Czaicki holds a BSBA in finance and an MBA, both from Saint Louis University. He is a CFA charterholder. Location: Dallas

Scott Krauthamer, CFA, CAIA

Scott Krauthamer is a Senior Vice President and Global Head of Product Management & Strategy, overseeing AB's global investment products across the firm's equity, fixed income and multi-asset strategies. Prior to joining the firm, he held a variety of investment and product-management roles at Legg Mason, U.S. Trust, Bank of America and J.P. Morgan Private Bank. Krauthamer started his career as an analyst at J.P. Morgan in 1998, and his financial-services experience spans investment-management, quantitative analysis, marketing and business development. He holds a BS in finance and management information systems from the State University of New York, Albany, and is a CFA charterholder and a CAIA designee. Location: Nashville

Why Passive Investing Isn’t a Panacea

What Happens When Crowded Trades Break?

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