Why Passive Investing Scares Me...Especially Now

Passive Investing blog imageFact: 50% of every invested dollar today is placed in index funds and exchange-traded funds (ETFs)

Over the last two decades, investors have moved to a DIY approach to investing. This is easy to do when markets are on an upward swing. But our world is much different than it was prior to 2000. I don’t believe the average investor understands the level of risk they are taking by buying index mutual funds and ETFs because they don’t understand how the investments work and how they are used by traders, hedge funds, and dark pools. 

When investor buys an index mutual fund or an ETF, they are buying a basket of stocks that mirrors an underlying index. There is no active management of the underlying investments and no consideration of the level of risk the companies within the portfolio are taking. The other factor that isn’t taken into account is that an underlying index is allocated based on the size of the company. So what? When big companies such as Microsoft, Apple, Facebook, Netflix, and Google, which represent over 12% of the S&P 500, go up, or more importantly, GO DOWN, they can determine the direction of the index as a whole, causing oversized gains or losses. 

Recently, we have seen all-time highs in the markets. How much of those highs are based on the overall performance of the whole index or just a few companies? And if we enter a recession, how fast will the indexes fall when the largest companies are subjected to a mass sell off? 

Do you really understand how much risk you are taking by investing in index funds and ETFs?

Why can active mutual funds be a better choice?

It’s simple. The majority of actively managed mutual funds control the weighting of the positions they own. They take the time to closely examine each company and analyze the risk metrics of each, thereby lessening the exposure to a mass sell off in stocks or bonds that are overweighted in an index. Does this mean that active mutual funds won’t lose value in a downturn? NO, but the losses could be much less than in index mutual funds and ETFs. 

There is rarely a true place to hide. But through proper active allocation management, the pains from the blows can be lessened and recovery can be quicker. 

Have questions? Please reach out to me. I love talking about investing and would love to discuss ways to help you avoid a financial crisis.

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Trent Grinkmeyer, AIF®, CRPC®, is co-founder of Grinkmeyer Leonard Financial, an investment, financial planning, and 401(k) management firm based in Birmingham, Alabama. Contact Trent at TAG@grinkmeyerleonard.com.

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