What is Passive Investing?
The first step in understanding passive investing, is to understand active investing. Active investing is the standard, and what most people think of when they hear the term “investing.” The simplest definition of active investing is that a person is making a decision about which companies they want to invest money in. Alternatively, this is known as active management.
Active management or investing takes different forms, but the common theme is that a person is ultimately making the decision. Mutual funds are managed by brokers who choose which stocks make it into the fund. An individual is an active investor when they decide to invest in Apple and sell stocks of Microsoft. Since the creation of stocks, all investments were actively managed until Jack Bogle created Vanguard.
In 1976, Jack Bogle created the “Vanguard 500 Index Fund” – a first-of-its-kind type of investment. When a person went to Vanguard and purchased a share of this index fund, the money was then taken and reinvested into each of the 500 companies listed on the S&P 500. This effectively allowed investors to invest in the entire S&P 500 in a single transaction with Vanguard.
This was the origin of the passively managed funds because there were no humans involved in the decisions about where the money would be invested. Once you said you wanted a share of the fund, the money went to investing in the broader US Market and no investment manager was on hand to make any changes to the companies listed in the fund.
At the time, this model was widely ridiculed as “Bogle’s Folly” and assumed that the new type of investment vehicle would fail. Now, more than 40 years later, the Vanguard Group has established itself as one of the leaders in this type of passive investing.
Common investors have chosen to invest passively for several reasons. First of all, it does not require any in-depth knowledge of business or ongoing work. Investors simply need to find an index fund that meets their needs, purchase shares and let it sit. There is no need to track individual stock prices or company stories if you have money in a fund that is invested across the entire market. Warren Buffett, the CEO of Berkshire Hathaway, has consistently said that index funds are the best investment for common people because they are not skilled stock pickers.
These types of investment are also diverse. Diversity, in investment terms, means that you do not have all your eggs in one basket. If all your money is in oil stocks and the price of oil drops, you are overexposed and bound to lose money. Diverse investments help to guard against risk. Mutual funds and Exchange Traded Funds (ETF) are major investment vehicles that seek to avoid risk by pooling different types of assets into a single fund. Index funds, like the Vanguard S&P 500, are a type of ETF. This video from Charles Schwab helps explain what an index fund is quite well.
Relevance in Reporting
As we saw during the Great Recession in 2008, the small actions of many people can end up having a crippling impact on the rest of the economy. The term “Passive Investing” is not inspiring or grandiose, but the interest and massive investments in these funds have created a bubble. More information here as well. Some research projects that passive investing will surpass active investing in the coming years. Bubbles occur when an asset’s value far exceeds its actual intrinsic value. Historically, when these bubbles pop they spell disaster for the rest of an economy.
Since index funds have become so popular, they have accrued notable ownership stakes in the companies they invest in. To illustrate this, we’ll look at the BlackRock “iShares S&P 500 Index Fund” – when someone purchases a single share of this index fund, they are allowing BlackRock to take that money and further disperse it across all of the individual companies listed on the S&P 500. So when you buy a single share of the BlackRock iShares Fund, BlackRock actually ends up buying a small portion of all 500 companies listed on the S&P 500. Amazon, The Coca-Cola Company, Facebook and Starbucks are all listed on the S&P 500. So every time an investor buys a stock in BlackRock’s iShare fund, BlackRock gains more ownership in these companies.
There are thousands of different index funds, but the biggest of these funds are run by Vanguard, BlackRock and State Street. The so-called “Big Three” of passive investing have accrued large ownership stakes in major companies through the proliferation of index funds. Combined, these three companies have over $3 trillion in index fund assets.
According to a Wall Street Journal article from late last year, Vanguard alone owns 10.4% of all US Stocks, 8.6% of which are under passive management. This matters because one company, Vanguard, has outsized ownership stakes in every publicly traded company in the US. Even if your understanding of the system is foggy, one thing is clear: there is an enormous amount of money and power concentrated within these few companies.
Investments under passive management may not directly impact your reporting today, but understanding this type of investment may prove useful in the future. Recessions are inevitable, and understanding their causes is essential when reporting.
Further Reading:
The Wall Street Journal, “Bogle Sounds a Warning on Index Funds”
Bloomberg, “Asset Managers With $74 Trillion on Brink of Historic Shakeout”
WBUR’s On Point, Podcast episode about Index Funds
The National Bureau of Economic Research, “The Spectre of the Giant Three”
Vanguard Website, Vanguard’s Remarkable History.
