The Risky Lure of Passive Investment Proxies

The most commonly cited reasons for the surge of interest in passive investing products are fee savings and skepticism about the ability of active funds to outperform. Most likely, these two factors explain a dominant part of the record flow into an ever-widening range of these investments, including mutual funds and ETFs. But they may not be the only reasons.

For some large investors, passive products increasingly serve as attractive proxies for a strategy that maintains a claim on the upside but also offers the possibility of a quick and cost-effective exit should elevated asset prices not be validated by improving fundamentals. And the more this set of investors grows, the larger the potential fallacy of composition (that is, what makes sense for some does not make sense for all), especially when applied to markets that lack structural liquidity (such as segments of high-yield and emerging markets).