There’s been a lot of outcry over the years about how passive investing is creating all these new risks. High fee active managers are always critical because they say silly things like “indexing is average” (see my response). Some other people say it’s hurting the economy (see my response). Others have even compared it to Marxism (see my LOL here). Okay, there’s a lot of hyperbole here mainly because there’s a lot of emotion surrounding a debate with huge gobs of fees up for grabs.  But are there real risks from passive investing?  While I think the risks are generally overstated I do think there’s one big risk:

First of all, if you’ve read my work on this subject you know that the term “passive” is a misnomer (read my long diatribe on this here). In reality, anyone who deviates from global cap weighting is being active. The main difference between an index fund like the Vanguard Total Stock Index and the Fidelity Large Cap Growth fund is that the Vanguard fund tries to match the market return in a low fee manner while the Fidelity fund sells you the hope of beating the market return in exchange for a high fee. The Vanguard fund accepts that, after taxes and fees, they will underperform their benchmark index (this is true for all of us on average). But by reducing these fees and taxes they actually generate better average returns than the more active fund. So, it’s not that the Vanguard fund isn’t active, it’s that it’s active in a more efficient way.

But this does not mean there is no risk in the less active strategy. In fact, I suspect the adoption of these strategies is a big part of why we’re seeing persistently high equity market valuations. Over the last 40 years we’ve seen a persistent creep in market valuations.  Ratios like the CAPE ratio or the equity market as a percentage of aggregate financial assets show that investors are increasingly overweight equities on average. It’s very likely that index funds put pressure on valuations by implementing overly simplistic investing models that convince people to be more overweight equities than they might be comfortable.