The Hidden Risk of Passive and Index Hugging

What is wrong with passive investing and index hugging?  One problem is that these strategies often use ETFs. I wrote about the potential for ETF meltdown last October, with a follow-up shortly thereafter, so I won't belabor that here.  Another problem is that most passive portfolios follow a cap-weighted index. Recently I also wrote about the risk from this. So I won't repeat that here, either. What I will do is add another risk that comes from the passive and index-hugging approach to portfolio management, the resulting lack of diversity in investment strategies and outlook.

The need for diversity is fresh on my mind because last week I was fortunate to share the stage with two academic luminaries, Andrew Lo, a finance professor at MIT , and Simon Levin, a professor of ecology and evolutionary biology at Princeton, at an event jointly sponsored by the BCG Henderson Institute and the Institute for New Economic Thinking. It took place at BCG's new office at Hudson Yards on New York's West Side, a place where shiny office buildings are popping up like sunflowers.

Andrew and Simon co-authored a paper arguing that financial regulation can learn from the regulation of biological systems. Andrew also has a recent book Adaptive Markets with arguments closely related to the same topic, that financial systems can be viewed as adapting to the changing, dynamic work in ways analogous to biological entities.

The essence of a biological system is that it is dynamic and complex, with the agents of that system facing unexpected changes in their environment. One way they meet the challenges of their dynamic world is to adapt through evolutionary changes. But in the biological realm evolution takes time, whereas the changes to their environment can be sudden. The more immediate survival mechanism in the biological realm is diversity, both across species and within any given species.

Diversity is the immediate result of sexual reproduction. There is a mixing of genetic traits, so each offspring is a little different. Which means many offspring are less than ideal for the current environment. In contrast, with asexual reproduction you get carbon copies of the parent, absent the occasional mutation. If the world keeps on going the same way and if the survivor in the assexual world is among the fittest for that world, then its offspring will be equally fit. The diversity in outcome from the sexual species will just add noise and inefficiencies in terms of survival.

The reason the world has largely moved to sexual reproduction is that things do not stay the same. Because the asexual species are all genetically identical, if things move the wrong way they all die off. But because there is diversity within any sexual species, there is a chance that some will have the characteristics to survive in the new system. Maybe those will not be the ones that are the best in the current system, and maybe they won't be the best in the new one, but they will be good enough in both.

Passive investing is the financial equivalent of an asexual ecology. That is, being asexual means it is not diverse. (And being asexual also means that passive investing, as many portfolio managers can attest, is not a lot of fun.)

The risk, then, is that with us all crowding into the same passive investments we will not have the diversity to adapt if something bad comes along.  But it is actually worse than that.  Being all the same might actually create the bad thing that comes along.  Because we don't just live in the ecology, we create it, and we create many of its shocks.  If things start going in the wrong direction, the effect of all of the passive investors moving in the same way, and the lack of deep-pocketed investors ready to take alternative tacks, will itself create the dynamic cascade.

By the way, this is a problem that is not restricted to passive investing, or even to finance.  I have written about the asexual capitalist, and how the same problem of a lack of diversity inflicts the capitalist system broadly.