Passive funds have many characteristics, but for the purposes of this discussion, let's focus on their set-it-and-forget-it rules based approach.
The prime example of a passive approach is to buy an index fund that follows one of the major indices like the S&P 500 or Dow Jones. Whenever these indices switch up their constituents, the index funds that follow them automatically switch up their holdings by selling the stock that’s leaving and buying the stock that’s becoming part of the index.
(Note: This is why it’s such a big deal when a company becomes big enough to be included in one of the major indices: It guarantees that the stock will become a core holding in thousands of major funds. Cough $TSLA
But the major indices aren't the only entities tracked by passive strategies. You can buy a passive fund tracking pretty much anything. From cloud computing stocks
, to 3D printing
The thing that makes them passive is that they have pre-set rules as to why particular stocks are included in the index, and rules that determine the allocation weighting these stocks get, and more rules for rebalancing.
Once all the rules are set and the fund is created, it acts like a Roomba rolling around your kitchen floor. When it hits a wall, the pre-set logic of the Roomba is to back-up and try a different direction:
When a passive fund "bumps" into an event that trips its business logic, it takes action. For example the WCLD index has rules that say it must equal weight it's holdings, and it rebalances twice a year
in February and August. So if one company is doing really well, and you think it will continue to outperform, too bad, the rules say it gets cut back to an equal weighting with all the other companies in WCLD twice a year.
What could go wrong here?
Well, imagine your Roomba can physically grow in size as it sucks up the dirt off your floor. And imagine your Roomba gets to be the size of a sedan (you're so dirty!) No matter how big your Roomba gets, it's going to keep operating under its rules. Pretty soon, instead of operating within the context of your room, it is the main entity deciding where your couch ends up, and whether your cat lives or dies.
If most people are investing in passive funds, there is a point where the active investors don’t have enough money to course correct it.
When the underlying value of the business doesn’t matter as much as the arbitrary rules of the index, AND the index has proportionally more money than the managers who are working out the underlying value, the price can’t snap back to the right value. The Roomba just keeps pushing the couch.
Value investors look for prices to come to them. But if there’s a backstop like the Fed keeping prices from coming back to the "correct" value, then index fund rules can dictate the price of assets more than other valuation metrics.
The "market" decides the price, no? And if the market is mostly passive funds, what does that tell you about the accuracy of the price?
Better hope the Roomba has good rules.