Every investing cycle has its favorite can’t-miss proposition…

In the early 1970s, it was the “Nifty Fifty” stocks — blue-chip growth stocks that everyone had to own.

In the mid-1980s, it was a scheme widely described as “portfolio insurance” — where big-money players hedged their S&P 500 stocks by selling ever-larger amounts of S&P 500 futures contracts.

In the late 1990s and mid-2000s, it was tech stocks and house flipping.

This time around, it’s passive investing.

A few months ago, I warned about the dangers of this seemingly no-risk strategy of investing in exchange-traded funds (ETFs) and index-based products.

It looks like others are starting to voice similar concerns…

There’s nothing inherently wrong with passive investing.

But like lots of things on Wall Street, it becomes a problem when everyone piles into the same system to the exclusion of everything else. When that happens, markets get distorted and the risk of bad things happening starts to rise.

And that’s where we’re at right now.

Recently, the chief U.S. strategist at Ned Davis Research told InvestmentNews that passive investing was developing into a bubble, but with an important distinction compared to other market distortions of past decades.

As the strategist noted, there’s no new investment tool or category. It’s just the way the vast majority of Americans have been convinced to invest their money: Set up an investment account, and tell the brokerage’s computer system that you want to buy X amount of ETFs or similar passive mutual funds each month.

In such a way, passive funds have absorbed $1.6 trillion from investors over the past decade, including a record $44 billion in the first quarter of the year…

A few months ago, I warned about the dangers of passive investing. It looks like others are starting to voice similar concerns…

(Source: ETFGI)

With passive investing, there’s no stress from picking a market-beating fund manager or scouring earnings reports looking for a particular stock that’s growing faster than most. Just plow money into ETFs and index-targeted mutual funds, then sit back and get rich slowly.

What’s not to like about that?

The problem lies in what financial wonks call “price discovery” (or the lack of it).

Think of an auction in which, every week, there are a dozen works of true art — Rembrandts, Picassos, Monets — alongside a dozen others featuring black velvet renderings of Elvis and questionable paint-by-number babbling brook landscapes.

But just as the bidding gets started, a “passive” art buyer shows up who overwhelms the auction and buys the entire lot of paintings, the good and the bad, without a question about price.

You can see the problem. Without an active bidding system, price becomes irrelevant. There’s no rational way to determine the good from the bad.

That’s the danger about passive investing in a nutshell. It can go on a long time, overwhelming skeptics simply because it’s been shown to work in the past — therefore, it must always work in the future.

After all, that’s the whole point of can’t-miss investing schemes. They do … until they don’t.

Kind regards,

Jeff L. Yastine
Editorial Director

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