Passive Investors Shouldn't Rest On Laurels...Active Investing May Be The Future

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The Wall Street Journal recently ran a front page article that cleverly illustrates the market sentiment shift against active funds.

Some of the highlights are:

* Last year, stock investors pulled $127 billion out of actively managed stock mutual funds, while pumping a net $70 billion into index funds and ETFs.
* This year investors have pulled $3.1 billion more out of actively managed stock funds. They have poured $45 billion more into the lower-cost alternatives.
* Legg Mason mutual fund soared 40% and beat its benchmark by a wider gap than any other U.S. stock fund with $50 million or more in assets, but investors have pulled $196 million out of it.

These three bullets paint a picture: investors are fleeing actively managed funds, and pouring money into index ETFs and passive mutual funds, which already are a powerful force in the market. If you are a fund manager overseeing a small pool of actively managed assets, this has to be a worrying trend. But if you are an individual investor, not subject to the whims of the masses, this should be an exciting development for you

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Utilizing the index as a financial product, however, changes market dynamics. And when that tool becomes the dominant product in the market, investors must ask, "Who's minding the shop?" Suddenly large portions of market participants are no longer "voting" for which companies deserve their investment dollars. They are simply dumping money into a product on the faith that the overall market will net positive returns. Those who are trading in and out of the index, are doing so based on their evaluation of broad market prospects as well.

The result is underperforming stocks get bought up in greater numbers because they are index members. Stellar companies do not get bid up high enough for the same reason. The streets have become crowded with pedestrians who can't or won't see the money on the street much like the two economists in the introduction.

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If you believe that the trend towards indexing will get stronger over the next decade, and you understand that indexing leads to individual stock mis-pricing, it's easy to connect the dots. The market, and therefore individual stock prices are determined primarily by overall economic sentiment, perhaps more than any other time in history. The market is not the perfectly rational exchange that economists imagine. It will become more and more common place for individual stock prices to deviate from their theoretical value, and they will stray from that value for longer periods of time. Investors who pick diligently hunt for bargains, and who have some aptitude for doing so will outperform those who passively invest in indexes. But if you still buy this argument, there are still two questions you should be asking.

1. What about the hedge funds? Won't opportunities simply be exploited by the growing hedge fund industry?
2. If "everyone" is investing in indexes, how will assets correct? Won't "index driven prices" be the new "normal"?

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