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The Problems With Passive Investing

by Paul-Martin Foss

Billionaire hedge fund investor Paul Singer recently warned of the dangers of passive investing. Passive investing has become an increasingly popular investing strategy among portfolio managers, as they merely seek to match the performance of various market indexes such as the S&P 500, the Wilshire 5000, and others. Matching markets is far simpler than trying to beat markets, making it easier for portfolio managers to pick assets and making it seem less risky for investors to invest their money. Given the historical returns generated by stock markets, matching markets rather than trying to outpace them are good enough in the minds of many people.

Not Trying to Create Value

One of the drawbacks to passive investing is that it doesn’t place pressure on underperforming stocks. Underperforming, in this case, doesn’t mean underperforming relative to the market, but underperforming relative to what the company could be doing. If a company’s stock growth matches markets, passive investing strategists will gladly invest in it and won’t put pressure on the company to improve performance. That means that investors are missing out on greater gains that could be made if the company were to better its performance.

Similarly, a fund that engages in passive investing won’t face any pressure to perform better if it matches the index it tracks. But if the portfolio managers have the ability to invest in stocks that may perform better than the market but don’t invest in them, they’re leaving money on the table.

No Shareholder Voice

Another problem with passive investing is that smaller shareholders often have no voice, or at least they fail to use the influence they have as shareholders. Because share ownership is diluted over hundreds, thousands, or even millions of individual owners, many of those owners don’t really care to get involved in the company’s internal issues. If the company continues to do well, they’ll continue holding the stock. If the company does poorly, they’ll sell the stock. Even though the shareholders are the owners of the company, they aren’t exercising the prerogatives of ownership.

That means one of two things. Either the company’s management can do what it wants without shareholder interference, which could negatively impact the company’s performance in the long run if management is inept, or a small number of stockholders can purchase just enough shares to dominate shareholder meetings and force changes on the company’s management that benefit the minority shareholders’ holdings to the detriment of all the other shareholders.

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