How Passive Index Funds Set Us Up for the Biggest Crash in History

August 9 2016

Over the past decade the debate between active and passive investing has reached a climax. Passive investing simply means investing in a fund that buys all the stocks in an index, assuming stocks have a historical return at some level. Recent numbers prove that the camp in favor of passive investing has been making strides. However, the case for passive investing is dead wrong. The surge in passive investors will set us up for the biggest market crash in history.

These Are the (Frightening) Numbers

Money has flowed massively into passive investment funds, or index funds in the form of exchange-traded funds or ETFs, whereas money has flowed out of actively managed investment funds. Active investing — stock picking, if you will — is out of fashion.

Relatively more money has flowed into passive investment funds than into actively managed investment funds. Source: Zero Hedge

And the success of passive investing was perhaps inevitable.

For years, many have defended the merits of passive investing. There are even “experts” that demand that (Dutch) pension funds should invest every dime in passive investment. And if even Warren Buffett agrees that index investing is by far the best option for many investors, then who are we to question the wisdom of this legendary investor?

Fortunately, historical returns do not convey omniscience to a mortal being about the future of passive investing.

This Is the Problem of Index Investing

These experts miss an important fact. They think that, from the perspective of an individual investor, index investing is the wisest thing to do. Of course, you earn the return of the index. You will not perform worse than the average, because you are investing in the average.

But the problem is the following: if everyone would invest in an index, then there would no longer be any price formation on financial markets. If no investor takes investment decisions on the basis of the fundamental value of a company, the stock market no longer functions as ultimate court or committee on the financing of companies: which companies should expand and which companies should be limited in their operations? Which companies are candidates for a take-over and which are not?

The stock market is the ultimate compass of the market economy. Without compass we are lost.

Amazon: Fundamental Value or Index Insanity?

Let’s take for instance Amazon. The fact that the shares of this U.S. online retail giant form part of a relatively high number of ETFs, and also has a large relative weight in these ETFs, explains for a large part the recent rally in the price of shares in Amazon.

In other words, companies that form part of the largest number and the most popular passive index funds (which in many cases are based on some kind of theme), see their share prices increase in larger proportion than other share prices.

The underlying value of a share — the company’s performance — no longer matters.

What If Everyone Withdraws their Money from an Index Fund at the Same Time?

I have warned multiple times about the risks of investing in junk bond mutual funds. In essence, this warning applies also in broader sense for passive index funds.

These funds are akin to a cinema with a single, tiny exit. If everyone wants to leave and go home at the same time, it is obvious that not everybody will fit through the door at the same time. Chaos results. In case of a fire, some will succeed to leave the cinema on time without incurring any damage, but others will be too late.

This analogy is extremely valid for these types of index funds. In case of any trigger for such a withdrawal of funds, for a selling wave of these funds, these index funds will have a downward pressure on equity markets we have never seen before. These index funds, which buy shares indiscriminately just because they happen to be part of a certain index or basket, will cause the biggest market crash in history, including in bond markets.

Make sure to figure out what the weight of passive index investors is in the investment your making, because any sentiment reversal will be devastating, more devastating than it has been in the past.

Opportunities for Alert Investors

This implies that as long as optimism rules markets, the stocks that are included in most (and the most popular) ETFs will rise the most. Not because the underlying companies are doing such a good job, but because it happens to be part of a certain index.

Better yet, we have clear historical examples that demonstrates what happens when a company is taken out of an index. As soon as a company is excluded from an important index, all these passive index funds are forced to sell the shares in question the very same day. The result? A volatile (but exaggerated) fall in the share price and often an investment opportunity for alert and patient investors.

The above also implies that these shares, that are currently outperforming any other share because their more often included in important index ETFs, will also underperform other shares in case markets crash. As soon as there is a reversal of sentiment, these stocks will be hit hardest. The knife cuts on both sides.

Biggest Crash in Stock Market History in the Making?

The increasing popularity of index funds should worry investors. With the slightest problem an enormous selling wave will force these funds to sell their underlying shares in exactly the same proportion or according to the same weight. The stock market crash in 2008, where markets crashed worldwide (the Dutch AEX stock market index lost half of its value), is a good indication of what awaits us, without ruling out the possibility that the next crash might turn out even worse.

Invest smart and avoid at least the shares or bonds that are included in the most popular of passive index funds to assure you will not suffer in a stampede when a large crowd is heading for the exit.

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