The Hidden Dangers of Passive Investing

Key topics

1. Popular Indices/ETFs Holdings: Many popular indices and ETFs have large holdings in the same stocks, which are often richly valued.

2. Price-to-Economic Book Value (PEBV): This metric indicates market expectations for future profit growth.

3. Growth Appreciation Period (GAP): The number of years holdings must grow at forecasted rates to justify current stock prices.

4. Fundamental Analysis and Due Diligence: Emphasizes the importance of analyzing fundamentals and conducting thorough due diligence.

Dangers of Passive Investing

• Crowded Trade: Passive investing has become very popular, leading to a crowded trade where many investors pour money into ETFs holding the same stocks.

• Market Efficiency: Over-reliance on passive strategies can reduce market efficiency, creating opportunities for active managers.

• Index-Inclusion Effects: Stocks added to benchmarks like the S&P 500 often see price spikes, leading to potential price distortions.

Overcrowding and Valuation

• Overlap in Holdings: A 2019 Bank of America study found significant overlap in stock holdings among mutual funds and hedge funds.

• Rich Valuations: Passive ETFs often have high PEBV ratios and long GAPs, indicating overvaluation compared to funds like the GMO Quality Fund.

Importance of Due Diligence

• Diversification vs. Diligence: While passive investing offers diversification, it cannot replace the need for diligent fundamental analysis.

• Opportunities for Active Managers: Stocks overlooked by passive funds can present opportunities for active managers to generate alpha.