The thought leaders of investment management industry are starting to admit major flaws in the passive investing model, even though they do not understand the full extent of the problem.

Bloomberg Starts to See The Major Flaws in Passive Investing

John Authers of Bloomberg Admits Major Flaws in the Passive Investing Model

John Authers, senior editor for markets at Bloomberg and a Bloomberg Opinion columnist wrote recently that there is a “strong case” that indexing is distorting market prices. This is refreshing even if it is long overdue. The mainstream financial press and industry titans such as Warren Buffett have continually beat the drum for passive investing, describing it as an unalloyed force for good. As with many manias throughout financial history, this one has been taken to an extreme and then some.

In his piece for Bloomberg, Authers mentions Inigo Fraser’s 2016 comment that “passive investing is worse for society than Marxism.” Fraser’s contention was that at least under Marxism there are (allegedly) intelligent people making decisions about how to allocate (and steal) resources, while under passive investing, capital is allocated using one of the world’s dumbest algorithms: float-adjusted market capitalization.

While the “worse than Marxism” was widely ridiculed at the time, Fraser turned out to be prescient.

The Leading Lights of Finance Are Still in the Dark on the True Scale of the Problem

Instead of recognizing the full scale of the problem with passive, Authers conclusion is incoherent: he faults passive for distorting the market prices but then says active managers “better start to find some stocks that beat the market.” He appears completely unaware that the investing game is rigged against active management and there is no way active managers can win — i.e. outperform. If indexing is the dominant source of inflows into the market, an active manager can find a very undervalued stock, but he cannot get its price to rise to fair value without someone else buying it. The best hope for this occurring in today’s broken markets is with a major stock buyback program or an outright sale of the company. This was cogently argued by hedge fund titan David Einhorn in his recent interview.  Good luck finding enough active investors to buy your stock.

Barring that, in a world where active is losing money year after year to passive, where does that logical buyer come from? In reality, a stock that has underperformed in the past will continue to underperform, and if a lot of active managers own it, the price could get hammered as their clients leave to invest in passive funds. Passive investing has created a gigantic momentum effect, which has killed the reversion to the mean function that has been a characteristic of markets for hundreds of years.

In short, the financial industry’s brain trust is starting to see the light on passive investing, even if they do not understand how deep the rabbit hole goes. The investment management industry is waking up to the major flaws in the passive investing model.

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