A passive investor doesn’t try to outwit the crowd. It uses the wisdom of the crowd to generate investment returns via passive funds, also known as index tracking funds.
An active investor will try to beat the crowd. Spending more money on research (and subsequently charging investors for that privilege) they will hope to gain an edge and therefore better returns.
In order for the stock market to function properly it needs active investors. It needs investors who want to buy stocks and investors who want to sell stocks.
Active investors create the market. Passive investors then piggy back on it.
Consider a street of 10 houses all looking and sized the same. The owners of house number 1 are actively looking to sell and a person comes along who is actively looking to buy. They agree a price and this is now considered to be the value of that property. As all the other houses in the street are the same they will also be considered to have the same value. The rest of the street are passive owners, seeing the value of the home go up and down depending on who is actively buying and selling in the same road.
This is what happens on a grander scale in the stock market. Lots of investment managers are actively buying and selling shares in business every day and therefore setting the value of these shares.
A passive fund manager will then come along and buy a collection of shares in different businesses based on the agreed price set by all the active managers.
There is lots of evidence out there that says that very few active managers beat the market (passive funds).
This is quite obvious when you think about it. It’s incredibly hard for active managers to get their buy and sell decisions right every time. Plus they need to ensure their choices do even better to cover their higher charges.
With passive funds you are always going to get the average.
For this reason and their lower costs, passive investing is becoming more and more popular.
In 2015 in the US alone, passive funds owned around 30% of US domestic equity funds. (Bloomberg)
By the end of 2020 that figure was 53%.
It’s a similar position for the rest of the world where passive funds now own around 41% of equity funds.
But if this growth continues and the large majority of money is managed passively. Who is going to set the market price for shares?
Could it be that the less active managers there are, the more chance they have to get an edge as they could potential manipulate market prices? Maybe.
Or if we all became passive investors would the market price really move?
Potentially big problems to come.
But it all comes down to the size of the passive market.
No one is really sure on how big passives share of investing has to be for markets not to function properly but it’s been suggested it could be pretty big, perhaps around 90%.
If you had 100 people looking to buy the same used car and 98 of them including the seller had no idea about cars or how much they should be worth but two of them were car experts. Do you think one of the two experts would pick up a bargain by the others lack of knowledge?
What would mostly likely happen is that the two experts would try to outbid each other which then ensures fair market value.
Another theory is that if the markets do become inefficient and there are price anomalies because of a lack of active managers then the few active managers left could thrive. But then this in turn could encourage more active managers to join the market meaning the market becomes efficient again, passive investing reduces in size and the cycle starts again.
I, nor anyone else knows for sure what is really going to happen that’s why I’ll never say I believe in passive investing over active investing. I do for now because that’s what the evidence shows works best but it doesn’t mean it will always be that way and if the data changes then I will re-adjust.
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Risk warning:
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.
