Passive investing won't cause the next crash...

MARKETS in Europe hit an intriguing milestone last year, writes MoneyWeek editor John Stepek in his Money Morning email.

Exchange-traded funds (ETFs) in Europe now hold more than $1 trillion worth of assets under management, according to figures from consultancy ETFGI (as reported by the FT).

That represents a doubling in size over the last four years.

A lot of people worry that this is some sort of bubble. Or that it's bad for capital allocation.

Let's have a little think about that this morning, shall we?

Exchange-traded funds (ETFs) are funds that are listed on the stock exchange. Unlike investment trusts, their share price should always (barring things going wrong) directly reflect the value of the underlying investments they own.

ETFs are also passive investment vehicles. All this means is that they track an underlying index. They don't try to beat it. This means that they are a lot cheaper than actively-managed funds, which do generally try to beat a benchmark or the wider market.

The underlying index itself can be just about anything. It could be the FTSE 100 or the S&P 500. If that's the case, the ETF will just replicate the performance of the FTSE or the S&P, less a small annual percentage fee (although in some instances, you can get ETFs that charge nothing at all).

The popularity of these sorts of passive trackers has soared, as more and more investors realise that they can get exposure to their own country's biggest companies at much lower cost than active managers will typically provide. Partly as a result of these lower fees, the passive funds generally deliver better returns too.

However, the index being tracked can also be something much more elaborate. "Factor" ETFs will track indices that are built around investing in stocks that have characteristics that have historically led to better performance. For example, value stocks or momentum stocks or small caps.

Or there are thematic ETFs, which choose a "hot" sector and then launch ETFs to capitalise on it. Current examples include cybersecurity, robotics, and a soon-to-be-launched "medical cannabis and wellness" ETF. These ETFs track indices that track companies which are active within these sectors.

You can see that the distinction between passive (merely tracking an index) and active (picking and choosing investments in order to beat the wider market) investing starts to become quite blurred here.

If you are building an index in order to launch an ETF that invests based on a specific strategy, or a specific sector, then are you all that different to an active manager who uses a value strategy, or who favours tech stocks or Chinese stocks?

To an outsider with no interest in defending one side or the other, you could argue that the only difference between the ETF and the active manager is that the ETF's strategy is more transparent, and you remove the discretionary human element – which in the vast majority of academic literature, generally causes more trouble than it's worth.

This is why I find a lot of the criticisms of passive funds to be rather too lazy for my liking.

Lots of people – not all of them with vested interests in the active management industry – worry that passive funds are in some way creating or contributing to a bubble in valuations.

I don't necessarily think that this is wrong. But this is not a black and white issue. You can believe a number of things simultaneously. For example, the rise of passive funds, in combination with a never-ending, central-bank-underwritten bull market, may well be distorting capital flows in some subtle or not-so-subtle manner.

There is also the ever-so-slightly more niche risk that certain passive funds may be creating an illusion of liquidity where there is none – in much the same way as the highly actively-managed Neil Woodford funds blew up last year.

But none of these potential problems makes passive funds in and of themselves, "bad" things. If investors weren't using passive funds to access the market, they'd still be buying it, probably using the same active funds that they've been pulling out of. People buy what's going up – that's the way this stuff works. Passive funds and ETFs are simply a new way to do that.

As for the liquidity issue – liquidity is something you must pay attention to when investing, and there's no doubt in my mind that come the next market crash (whether it's ten months or ten years from now), we will see certain ETFs or pockets of ETFs blow up or struggle to cope.

However, the same will apply to actively-managed funds. Any financial vehicle that offers its investors more liquidity than actually exists in the underlying market in which it invests is setting itself up for trouble in the future. As Woodford – who I will note again, was an active manager, Britain's most famous one at that – amply demonstrated last year.

In short, passive funds are just an evolution of financial markets. Will they be involved in the next crash? Of course. They're now a fundamental part of the market. But will they be the cause of the next crash? No.

And in the meantime, as long as you understand what the ETF or passive fund that you buy is actually investing in, then most of the time, you'll find that they are cheaper and preferable to the active alternative.

That's the point of evolution – to improve things. Sometimes that happens – even in financial markets.