11 trillion is now invested in index funds, up from $2 trillion a decade ago. And as of 2019, more money is invested in passive funds than in active funds in the United States. That creates both problems and opportunities for people investing in individual stocks. Simon Erickson, Matt Cochrane, and Steve Symington joined Dan Kline to talk about passive investing on the April 9, 2021 edition of 7investing Now.

A transcript follows the video.

Dan Kline: So let’s get to it is passive investing ETFs and index funds bad for the stock market? Simon, why don’t you kick this off and sort of explain something? I didn’t know that as of 2019, there’s actually more passive money in the market than there is active money by active money. I mean, individuals and fun and sometimes, you know, money managers going in and buying individual stocks, rather than buying ETFs, which are baskets of stocks, more or less.

Simon Erickson:  Yeah, that’s right then and what we mean, kind of like you said, passive versus active investing, right? Are you an active investor? That’s actually making trades, picking stocks and buying them individually? Are you putting your money wrapped up into an ETF or a mutual fund that’s making those decisions for you, that tends to buy large baskets of stocks. And as you alluded to, Dan, we’ve now seen that passive funds these these passive vehicles for investment, now have more assets under management than actually actively traded stocks do in the United States. That’s having some impacts to the market. A lot of people call this dumb money, it really just means that kind of baskets of stocks move in tandem together, and introduces a lot of noise, which actually has some interesting implications for individual investors like us.

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There is $11 trillion passively invested in the stock market

Dan Kline: Steve, let’s get your 10,000 foot view on this. Before we go into some of the nitty gritty I will point out, there’s $11 trillion passively invested in the market, which is the same number it would take to get me to visit Steve in the winter. So see if your thoughts on it. Yes, in passive investing which a lot.

Steve Symington:  So, passive aggressive, passive, and I want to say passive aggressive, passive investing, you know, it might actually be degrading, you know, some of the the advantage of individual investors because what we see is massive amounts of cash kind of moving, as Simon mentioned earlier, and a lot of different sort of similar stocks and similar baskets moving in tandem with one another. So, it’s harder as individual investors and a stock pickers to find businesses that will materially outperform the rest of the market. So that’s kind of the idea is, is how, you know, passive investing the so called dumb money, so to speak, is creating issues for stock pickers who are actually trying to create alpha, really, and yeah, that’s a legitimate worry.

And, you know, we you can kind of argue that there is cause for concern, but it’s not sort of this yet a such a broad sweeping concern that I think that it’s impossible to beat the market. And that’s something we’ve sort of proven with, you know, our individual track records and our track record as a team. So far, it’s seven investing is it is possible to beat the market, but it definitely gets harder when you have so much money moving in tandem.

Dan Kline:  So I’m gonna liken this to horse racing. I’m gonna go back to Simon in a minute as planned in our script here, Matt Cochrane, if you ever bet the ponies – have you ever gone to the track?

Matt Cochrane:  I’ve not I’ve never been to the track. So no.

Dan Kline: So when you go to the track, how people bet is what creates the odds somebody is feeding back. So be careful with your speakers there. But it is one of those cases where if a horse has a great name, and the example I’ll give is I was at the Belmont, which is in New York one year, there was a horse named Captain Messier named after Mark Messier. And it was a bad horse that had like three legs and a limp like it was not that its jockey weighed 400 pounds, this horse wasn’t going to win, but a ton of money went on it and it became a favorite.

That can happen in the market, we saw that with with the GameStop craze. That’s active money. But if there’s so much passive money in a stock, that actually makes it harder for active money to sort of push stocks in the right direction, or sometimes the wrong direction. But Simon, how is this impacting the market right now? Is it just increasing volatility and noise? Or is it? Or is it having real impact?

You don’t have to follow the herd

Simon Erickson: It’s herd mentality, Dan. And you know, if we kind of take a step back and go back in time and look at how money has moved and changed over the last several decades, right 1978 comes out with a 401k plan. And this is a defensive investments a passive investment for the most part, because you have these giant funds that are helping people invest for their retirement, right, we’re moving away from pensions, which were defined benefits to defined contributions, the 401k. And we put it in these giant funds that would kind of track along the entire market. By the way, I have a bit of trivia for Archie here on the show. And anyone who’s watching, do you know what the largest mutual fund in America is right now?

Dan Kline: I don’t have the teacher’s edition. So I don’t actually know the answer to this one.

Steve Symington:   I’d say maybe the Vanguard S&P 500 index.

Simon Erickson:  And that is correct. This is the Vanguard total stock market. You know, Steve, you get the gold star today for picking that it has $1.1 trillion of assets. And it’s spread over 3000 different positions. That is the entire market, you’re buying the entire market with that. And there’s now a trillion dollars of assets that just flowing with something so broad based like that. And then you look at also other, you know, innovations in investing his Roth IRA in 1997, this was also a defensive one, you kind of save for your retirement, you did not want to take risk.

But then in just the last decade or so we’ve seen kind of more of a rise in algorithmic trading that is in sub sectors of the market, Dan, so rather than going out and blasting 3000 positions me what we might go out and find an ETF that’s just based on space economy, on retail on financials, whatever it might be. So you’ve got these sub pockets that move in tandem, that could still be 10s of billions of dollars of assets. And so I guess my key takeaway from this is this is kind of evolved from a retirement Park and forget about it for 30 years kind of vehicle that we’ve seen, it was very defensive in nature to more offensive playing offense, investors looking for pockets of the market they want to invest in, but it’s still herd mentality. It’s still grouping a basket of stocks together rather than individual companies.

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Dan Kline:   So I’ll make a silly comment and then a serious one, I sent you guys a photo of my new license plate because it’s in a 7investing license plate holder. That being said, my license starts with QQQ, which is a popular NASDAQ ETF. So I feel like given what I do for a living that my license plate is inadvertently sending the wrong message because of I didn’t get to pick it. If you see me out there, I was going to share this on social media. And then I thought that maybe having my license out there, my license plate out there and social media wasn’t a great idea.

But Simon and Steve, we’re gonna get back to you in a second. I know that I don’t consider my retirement accounts, my 401k, specifically, totally passive, because I look at what’s being bought. And I know that I have exposure to some things I’d like to own individually, but I don’t I have significant Amazon exposure, for example, in my 401k. So I consider that owning Amazon. I know most people don’t dig into the holdings of what they have. But is this mostly just people saving for retirement that are that are sort of setting it and forgetting it?

Simon Erickson :Steve, you want to go ahead? I have an answer. But please take the time.

Dan Kline:   I was throwing it to you, Simon. But Steve, you can go.

Steve Symington: I’d say yes. And no. I mean, that’s a lot of it. But, you know, I think there’s a lot more young money going into the stock market, kind of as people have more disposable income and realize that it’s a fantastic wealth generation tool. But I don’t have a particularly informed prepared opinion on that. Simon, what do you think

Simon Erickson: Yeah, I mean, Dan, it was very highly structured by employers for so many years, right? For those watching to program that were investing 20 years ago, you remember just the charts that we show the one year, five year and 10 year return of your five options you have to put into your 401k plan. I mean, it wasn’t going out. And most people weren’t looking at, you know, the this perspective, the summaries the constituents in those in those funds. But now you’ve got so much access to information, you can go through and read annual reports, you can kind of look at individual equities, and be much more selective about exactly the companies you want to invest in. I think that investing as a whole is continuing to evolve to evolve. And even though we’re seeing the rise of these passive funds grow larger and larger in absolute terms, it’s also a greater and greater opportunity for companies like ours and individual investors that now have access to more information to make even better informed decisions.

Start early and invest often

Dan Kline: Absolutely. The more information you have, the more you know. And that’s why one of the things I push when I explained 7investing, and I spoke to some 17 year-olds yesterday in a sort of socially distant setting. And they were really into some really weird stock areas. And what I kind of said was, start with what you know, and the reason for that they were talking about lithium mining in, you know, like, I don’t I don’t even remember where but like South Africa or something. And it’s like no, look around your world and figure out what you know, because you’ve been following that business. Part of what we bring here is whether it’s a company we’ve experienced, or companies we’ve just been following for decades, is historically you build up that wealth of information. And now it’s easier because the technology is great. Like we’re partnered with Ycharts and Ycharts put so much information at the at the tip of your fingertips. We’re going to take your questions and comments if they’re not related to this. We’re going to do it in the second half of the show, sort of after what we’re watching, but I wanted to take a comment on the first one from Mike Fee. Sam Bailey and Matt Cochrane, if you wouldn’t mind reading that comment out loud.

Can passive investing hurt the market?

Matt Cochrane:  Yeah, absolutely. Bill Ackman discussed this issue back in 2016, suggesting there is a bubble in indexing the argument. If everyone becomes a passive indexer, then the returns of the major indexes will start to lag in a major way as the stocks in the index become overcrowded and overpriced. And then can I just follow up on that comment?

Dan Kline: You can.

Matt Cochrane:  So like Michael Burry, said that actually the same thing, and like I want to say 2019 maybe but he says like, you know, passive indexing, passive investing, it just kind of like ruins price discovery, because there’s no more price discovery people just like essentially, like, even as they put away money in retirement, they’re essentially just blindly putting money into like, you know, if it’s the s&p 500 index you’re blindly putting money into 500 names. Right. And so that you’re ruining, like price discovery, and that this will you know Michael Burry from you know, he was the investor featured in The Big Short Movie who got the 2008/2009 financial crisis famously right. But he said the same thing, that it was like ruining price discovery, and that like it would eventually cause a bubble.

Dan Kline:  Based on my height and efforts at the gym. I’m going for the name Big Short. Simon, is the retail investing craze. And I it’s a weird thing to talk about, but there’s a lot of new money, dumb money for the most part in the market. Is that offsetting some of this though, I’m not entirely sure the Reddit investors are buying, you know, shares of Starbucks and Microsoft or, you know, other heavily owned companies.

Simon Erickson:  It’s herd mentality that we need to be aware of Dan and I think it favors the investors like us that want to do our homework and see if this seems reasonable or not, right. Like when you see a company that misses a quarterly earnings report by one penny on earnings per share, and then the stock sells off 17 20% crashes, that’s not normal. That’s algorithmic trading that’s got billions of dollars behind it that just is saying, Oh, that’s a mess. We’re selling off. individual investors can take opportunities like that to buy To great positions that sell up for the wrong reasons, it works.

The other way to say there’s a ton of money flooding into premature technology that isn’t ready for mainstream, it isn’t commercialized yet, we start to see bubbles, you’re locked into some of those bubbles. If you’re buying into the ETF that has a basket of those stocks, if you’re selecting individual companies, you don’t have that same kind of exposure. So I think net, this is actually a kind of an exciting, good time for those that are willing to uncover some more stones and do some more homework.

You have to play to win

Dan Kline: I want to speak to the comment from So Fly Marketing, because it kind of brings up a point, we’re not saying don’t invest in your 401k. Sam, if you want to bring that one up happy to share it with the audience. My 401k doesn’t let me pick individual stocks, I only put it enough to get my employer match because at least that’s guaranteed 100% investment. Absolutely. So what you want to do in your 401k is use the tools it gives you to match your investing style, your age, there’s only so much you can customize in your 401k. I am a company to myself, so I have a little bit of control over my 401k.

But it’s still only what’s available in the tool that you know, in the payroll company I use that has the 401k you can only pick so much. But company matches are free money. So I don’t care how well you think you’re going to do in the stock market. If you have a 5% match, and you put the money in the amount you’re allowed to put in that is a guaranteed return on top of it, you know, whatever you get. So even if you just perform with the market, so it’s about 9% a year on average, and you got an extra 5% that’s gonna push you into some really strong returns, and they’re guaranteed you don’t want to give that up. So yes, this could be a problem. But it’s not a problem because of the $6,000 a year you’re putting into your 401k. Simon Erickson, let me give you the last word before we move to what we’re watching.

Simon Erickson: I think the biggest overall win for investors from this entire trend, Dan has been the reduction of fees. It used to be standard that hedge fund managers are making two or 3% of the assets under management just as a management fee. It used to be when you were trading stocks, you sometimes had to pay commissions, if you remember way used to be 20 $50 just to buy a stock. Now we’re not even talking about any commissions at all, for buying individual equities. And all that information to kind of use to be behind the curtain is now available for people that are interested to take advantage of.

And so when you’re paying lower fees, you’re paying two or 3% lower fees you’re getting, by definition, a two or 3% better return on your results. And now that you have access to buy and sell securities at an individual level, this is going to return that this is going to be a net win for individual investors because you’re getting better returns. That’s the biggest innovation of all. And when we look at the kind of higher level of how capital is moving around out there,

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