A few months ago, I warned that passive investing — long a worthwhile, admirable trend fueling the growth of exchange-traded funds (ETFs) — was in danger of becoming a mania.

Until now, few on Wall Street have really cared. I mean, if the main thing is to keep increasing “assets under management” — hopefully in ETFs owned and managed by your investment bank — then you want this trend to go on and on.

But that’s starting to change.

Passive investing presents a “frightening” risk to the markets, said a top Morgan Stanley strategist on CNBC in recent days.

Hans Redeker, the bank’s global head of foreign exchange strategy, put it plainly: “When you have people getting more involved with passive investment strategies, the market will be less able to react to minor distortions or minor declines on the fundamentals side.”

Translated, he means that a big decline in the stock market is going to come seemingly out of nowhere.

Never in the relatively short history of passive investing has that danger been higher than now.

  • BlackRock — the world’s largest asset management firm (and owner of all those iShares ETFs) — said it saw record inflows of $74 billion.
  • Bank of America Merrill Lynch said $4 billion flowed into growth stock ETFs last week — the highest amount on record.
  • Among investors’ allocations of stocks, bonds and cash, most are choosing to keep only 10% of their money in cash — near a record low — while devoting 60% to stocks (likewise, close to a record high).

Passive investing presents a “frightening” risk to the markets, said a top Morgan Stanley strategist on CNBC in recent days.

The point I made back in May, when I last wrote about the danger of passive investing when it becomes a “can’t miss” strategy, was that ETFs are akin to a weekly art auction where the biggest buyer sweeps in 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.”

The danger alluded to by the Morgan Stanley strategist is that price stays irrelevant — until it’s not.

On that day, investors will wake up and realize that it’s very relevant indeed, as they’ve let themselves be bamboozled, flimflammed and conned into buying stocks at sky-high record prices…

For the third time in 20 years.

Kind regards,

Jeff L. Yastine
Editor, Total Wealth Insider