GOLDMAN SACHS: The stock market stops working when there are too many passengers

Goldman Sachs' partner and global co-head of the investment management division Tim O'Neill has a warning: if passive investing gets too big then the market simply won't work.

"So in terms of the size, a market needs both active and passive investing because if everybody's a passive investor, there's no one to buy from. O'Neill said on a new "Exchanges at Goldman Sachs" podcast with communications chief Jake Siewert.

"And if passive becomes a certain oversized percentage of the market, the market doesn't function."

O'Neill is getting to the heart of the debate on active versus passive investing. Passive investing has boomed in recent years, with index-tracking exchange-traded funds hoovering up trillions in assets under management.

The problem is: the market needs active management, otherwise there will be no one to buy from, and individual stocks will just move with the overall index.

As a result, O'Neill, who previously called passive investing "a potential bubble machine," said that both strategies are necessary.

Here's an excerpt:

"Well, the promise of active investing is that they're going to deliver performance net of fees better than the benchmark, whatever the benchmark might be for the US, global, or Europe. It's been a difficult seven years for active investors because the markets have risen so consistently and persistently higher. So most active managers have net of fees underperformed the benchmark. So it led back to this debate about whether or not the fees that you pay for active managers are worth it. And there's been simultaneously a great shift towards passive investing because it's cheap, and you would get all of the market returns, net of five or ten basis points. The problem for passive is that its size, at a certain point, may be too much for the market to handle. And it's also all on autopilot. So in terms of the size, a market needs both active and passive investing because if everybody's a passive investor, there's no one to buy from. So there's no one...your beta is my alpha and vice-versa. So you need a balance in the market. And if passive becomes a certain oversized percentage of the market, the market doesn't function.

"The other problem with passive, of course, it's all on autopilot. And when you get to periods of misvaluation, over or undervaluation, you need active decision-makers. Because valuation always matters in markets, and investing."

O'Neill's division is primarily in the business of active investing. This month, Goldman Sachs Asset Management launched its first exchange-traded fund (ETF), the ActiveBeta US Large Cap Equity ETF (GSLC).

Listen to the full podcast here»