July 17, 2017

Picking stocks is an art form that is dying a passive death. I say “passive” because the influx of passive investing into the market has taken a lot of business from investment advisors.
But investments that track the market, or segments of it, are a house of cards in themselves. Sure, the upside is promising. But we haven’t seen how they react in down markets.

Since so much is invested in them, one would think that market downturns would cause big, swift reactions from indexed investments. But we’ll find out. Market corrections are a matter of when, not if. Evidence lies in price-to-earnings ratios that are high, even for “boring” stocks. The market is overpriced. In time, there will be more sellers than buyers.

But it begs the question, when investors want to sell their indexed investments, who will buy them?
On top of that, passive investing is removing the market function of capital allocation, which can be seen when poorly managed companies have rising stock prices. Remember, facts don’t matter to the market now.

Consider this – the five biggest stocks in the S&P 500 represent 42 percent of the entire NASDAQ 100. They are Apple, Google, Microsoft, Amazon and Facebook. Apple alone is 12 percent of the NASDAQ 100 Index and 4 percent of the S&P 500.

So, that means $0.42 of every $1 invested in a fund based on the NASDAQ 100 goes to Apple, Google, Microsoft, Amazon and Facebook. The remaining $0.58 is spread among 95 other stocks.
With so much investment concentration and overall volume, there’s a real possibility funds could begin trading below their net asset values. That could result in the indexes will drop much faster than they rose.

It begs the question – are we automating errors through passive investing?

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