“One reason for the disparity (of underperformance) is that active managers don’t bet the ranch with your money,” said Boston-based DALBAR’s CEO Lou Harvey. “They hold some aside for the time when things go wrong. This protection takes away from gains, since a portion of your money is held in low-yielding cash and bonds.”

Even worse, investment consultants often press active managers to minimize their cash component, saying that they, the customer, determine how much cash to hold. “That’s like tying one hand of a boxer behind his back. It makes it much harder for the portfolio manager to operate,” said Harvey.

The Growth Of Passive Funds, And What That Could Mean For The Future

Passive funds have grown into a major force, according to the Swiss-based Bank of International Settlements. In the United States passive funds amount to about $8 trillion, or 20 percent of $40 trillion in investment fund assets, as of June 2017.

Lately, most equity money invested in the United States funds has gone into passive strategies following their strong outperformance. For example, passive U.S. funds took in $506 billion in 2016. Active managers endured withdrawals of $341 billion over the same span. Since the financial crisis, active managers have underperformed across most categories.  

Some futurists see the trend as permanent, the adoption of “a new technology,” wrote Moody’s Investors Service in 2017 when it predicted that passive investing will overtake active in just four to seven years, as early as 2022. Adoption “will continue irrespective of market environments.”

But other investors see trouble ahead with so much money resting in these pools without a watchman. Charles Brandes, founder and chairman of San Diego-based Brandes Investment Partners, is one of the few voices that have sounded the alarm of a financial bubble brought on by this surge in passive investing. Brandes points to what he sees as an extreme investor obsession over fees, and a single-minded emphasis on short-term results. Both have come to the fore in the latest and longest running bull market.

With bubbles, price dislodges from intrinsic value, said Brandes. Passive management is just that, it does not care about the valuation of any of the companies it invests in but rather each of their weights in whatever index it is trying to mimic. Bubbles are difficult to catch because they can only be realized in retrospect, no matter how frequently the word is used on broadcast television. Witness the dotcom bubble with its eyeballs, soon replaced by pathway to profitability. Or the housing bubble with its fervent belief that house prices could never fall.

One particularly cautionary voice is Ned Davis Research, the Florida-based investment advisory firm made the following prediction last March 2017: “We are in the last phases of a passive index bubble. I think over the next five years there will be great opportunity for active managers to outperform passive managers.” An Opportunity for Asset Managers?

The Costs And Benefits Of An Active Manager