Passive Negligence

The stock market is an essential cornerstone of capitalism, not a game of roulette. Well-functioning and free capital markets properly regulate the cost of capital, which is a vital input allowing companies to analyze the cost and benefit of investing and the economy to run efficiently. When investors fail to analyze assets and blindly invest in the capital markets, they distort capital valuations, misallocate capital and as a result economic prospects weaken.
The Federal Reserve (Fed), in historic efforts to increase debt and further stimulate consumption, has taken extraordinary actions to lower interest rates to levels never seen before. Low interest rates encourage consumers to borrow and spend. They also encourage investors to speculate instead of investing in more productive endeavors. From the Fed’s perspective, speculative behavior drives financial asset prices higher and generates a so-called ‘wealth effect’. The hope is that, as investors grow wealthier, they consume more goods and services. Additionally, the increased value of assets can be used as collateral for new debt, allowing for further growth in debt and consumption.
One of the consequences of a ‘managed’ economy, such as the one the Fed has created, is that the normal functions of a capitalistic society erode. Capital is misallocated in a behavioral response to policy, and asset price inflation emerges in a divergence from economic fundamentals. One of the manifestations of this reaction by investors is the recent rise in popularity of passive equity investing. This mindless style of investing has implications that few investors appear to consider. It is important for investment managers to understand the consequences of passive investing. The sizeable and growing source of demand for equities due to interest in passive strategies may generate a short-term boost to valuations, which helps explain the cheerleading, but the intermediate to longer-term effects seem destined to be quite damaging.

This post was published at Wall Street Examiner on November 2, 2016.