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5 Common Misconceptions About Passive Investing

The passive investing in ETFs and index funds has experienced a massive influx of money in the past 10 years. The U.S. ETF market is quickly approaching $3 trillion in assets under management (AUM). As of March 29, 2017, the total AUM for U.S. ETFs was equal to $2.78 trillion. Even though the value of the U.S. ETF market is still dwarfed by the $16 trillion mutual fund business, it is growing at a steady pace of $300-400 billion annually and slowly catching up.

Inevitably, passive investing will continue to grow while active investing continues to shrink until they reach some equilibrium level.

A lot has been said and written in the media about the benefits of passive investing and indexing—low fees, easy access, daily pricing and tax efficiency among others. However, in this article, I would like to point out a few misconceptions investors should be aware of.

1. Passive Investing Is Cheap

One of the main slogans of the passive investing campaign is it is cheaper than investing in active mutual funds. Indeed, some of the large U.S. ETFs are now charging as low as 0.04% while many active managers are still asking for 1% to 1.5% in management fees.

However, some less obvious costs remain hidden and misunderstood by the average investor. ETFs have two large expense categories, transactional and holding costs.

Transactional costs include trade commissions, bid-ask spread and market impact. Holding costs include management fees, index tracking error and taxes. Without getting too technical, holding larger and more liquid ETFs such as SPY and VTI will minimize these costs, while trading smaller ETFs can drive higher transactional or holding costs due to poor trade execution, higher fees and significant index tracking error. (For related reading, see: ETF Tracking Errors: Protect Your Returns.)

2. Passive Investing Always Beats Active Investing

It is somewhat true, but not always. According to a recent study by PIMCO, 46% of all active equity fund managers and 84% of all active bond managers over-performed their median passive peers in the past five years.

In practice, passive investing will perform very well in efficient market segments such as large-cap stocks, where most companies receive a full publicity and research coverage. On the other hand, active managers will do better in more fragmented and less efficient asset classes like small-cap, emerging markets, and even fixed income. These markets have a lot more room for mispricing and price discovery due to fragmentation of market players and lower research coverage.

3. Passive Investing Gives You Control

Intuitively it makes sense to think that passive investing provides more control on your investment decisions. After all, you are not paying an active manager to pick and choose your stock holdings. But, and there is always a but, most passive investment strategies are market cap weighted. That means whether you invest in S&P 500 (SPY) or Total Equity Market (VTI), a significant portion of your money will go to companies like Apple, Microsoft, Exxon Mobile, Amazon, Johnson and Johnson, General Electric, JP Morgan and Wells Fargo. In fact, you have no choice. The top 10 companies in S&P 500 make up 19% of the index and the remaining 490 stocks make up 81%. Indices are already set and you will simply follow their performance. 

4. Passive Investing Is Less Risky

Investing comes with risk. And passive investing is as risky as any other form of investing. Passive investors are equally exposed to losses during bear markets, sudden market corrections or just following the wrong index. In fact, many ETFs are becoming a popular tool among traders and hedge fund managers to park extra cash or quickly get in and out of certain positions. Sudden large inflows and sell-offs can impose significant risk to smaller retail investors due to an imbalance of trading volume between ETFs and their underlying securities. (For related reading, see: The Biggest ETF Risks.)

I also want to point out the increasing presence of exchange-traded notes, leveraged, inverse, commodity and volatility ETFs. They carry a significant risk to investors and should not be used for long-term retirement planning.

In contrast to that, many active managers use risk-adjusted measurements like the Sharpe ratio, information ratio, Treynor ratio and Alpha when assessing their performance to their respective benchmark. As a result, many iconic active mutual funds lost a lot less than similar ETFs during the last 2008-2009 bear market mainly because of their strong risk management policies. Not to mention that many of the ETF newcomers have not been tested in a bear market at all.

5. Passive Investing Is Efficient

ETFs trade daily and have intra-day pricing like any other stock on the exchange. Naturally, ETFs were designed as a vehicle to provide liquidity and transparency in the marketplace. However, there have been numerous occasions of significant ETF market mispricing. On August 24, 2015, due to a flash sale, several ETFs lost more than 40%–50% of their value in a matter of seconds before they recovered.

More recently, on March 20, 2017, a computer glitch on the largest ETF Exchange, NYSE Arca, caused significant delays and mispricing of thousands of ETFs. (For related reading, see: NYSE Trading Glitch Could Pinch ETF Investors.)

Final thoughts

While "passive" implies a lack of participation in the investment process, in reality, there is no true passive investing.

The fast growth of ETFs and the index fund industry will drive down management fees and put pressure on active managers' performance. However, it will not eliminate the need for involved investment decisions. Investors will continue to make choices about their financial goals, retirement contributions, taxes, diversification, asset allocation, investment options and benchmarks.

(For more from this author, see: 6 Proven Strategies for Volatile Markets.)