No, Passive Investing Didn’t Crash Your Market.

Businessman concept,  Active or Passive road to the correct way.

A popular theme toward the end of last week was to blame passive investment products for the market’s decline. There is no evidence for this, and I have yet to hear anyone credit passive investing for Friday’s and today’s rebound, but passive’s critics place their blame anyway.

This is part of a recent “if you can’t beat ’em, call them dangerous” strategy that active managers are employing. As the evidence becomes more and more overwhelming that active management is a rip-off for most investors (worst of all for most hedge fund investors, most of whom really are the dumbest money in the market for paying 2 and 20 to their hedge fund managers for consistently sub-benchmark performance), active managers have put less effort lately into resisting that evidence and more into accusing passive investors of wrecking the markets. Again, this argument is evidence-free; it never comes with data to back it up.

Instead, there are very good reasons to believe that passive investment, if anything, is making markets calmer, not more volatile. After all, an investor in Vanguard’s S&P500 index faces only the highly-highly diversified return of a market-weighted portfolio of more than 500 securities (because there are some dual-class shares in there). When on Friday, February 2, 2018, the S&P500 closed down, I strongly suspect that 99%+ of Vanguard’s index investors had no idea that L Brands Inc. was down 21.11% for the year, or Chesapeake Energy Corp. was down 15.91%, or Ford down 12.09%. Some may have been watching closely enough to know their index investment was still up a bit over 2% in total for the year, but many probably weren’t paying attention at all. They were working their day jobs or, as in the case my kids’ 529 plans, in grade school studying and talking with their friends.

Those most likely freaking out that day and Monday of last week were the active managers and their algorithms (and I have nothing against algorithms). No one at Vanguard was worried about losing their job because they made a bad investment decision in the S&P500 index fund. But someone at Janus or Citadel or Greenlight or Perry Capital (… oh wait, they are gone now, right?) might well have been.

Nothing looks quite so Zen at a time of market volatility as an index fund. Most S&P500 index investors entered last week knowing (1) that in 2017 they again crushed many hedge funds (including many marquee names) at a tiny fraction of the price; (2) they were highly diversified; (3) they were up for the year 2018; and (4) that essentially no decision of their own – other than to invest in the financial product most endorsed by smart and honest financial advisors and academic financial economists – was on trial. That’s a pretty good place to be.

This isn’t to say that some investors didn’t or won’t sell, or that selling wouldn’t be a perfectly good decision. Valuations are high, interest rates are increasing, etc. etc. And it certainly isn’t to say that sector speculation into all “passive” ETFs is a good idea. That’s not what I’m defending. There’s not much passive about that.

But the bulk of passive investment in the largest U.S. equities is not only the smartest money out there – smart enough not to get fleeced by poorly-performing active managers – but is also pretty calm. Don’t point your fingers at them.