Best-selling author James Rickards explains how 'parasite' passive investors will make the next market downturn 'like a runaway train with no brakes'

  • Best-selling author James Rickards rips into passive investors, referring to them as "parasites" and "free riders."
  • He bases his argument around passive investors' indiscriminate purchases of index funds, which he says essentially contributes nothing to the marketplace.
  • He also sees the shift from active to passive investing making the next market crash much worse due to a cascading effect.
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Passive investing has been touted by the investment community as a cure-all strategy for those uninterested in going for the outsize gains that stem from speculation.

For the uninitiated, passive investing is a simple strategy where the objective is to invest in low-fee index funds that are aimed at mimicking a broader benchmark, such as the S&P 500, Nasdaq, or Russell 2000. Once a purchase is made, it's held long-term to minimize the transaction costs associated with buying and selling.

But not all are jumping on the passive investing bandwagon - and some are extremely critical of the movement.

"Passive investors are free riding on the hard work of active investors the same way a parasite lives off the strength of the elephant [active managers]," James Rickards, author of three New York Times bestsellers, said in a recent blog post. "What happens when the passive investors outnumber the active investors? The elephant starts to die."

This take is at odds with the majority of the investment community. In fact, Warren Buffett famously responded to an inquiry about how his trustee should handle his estate with the following comment: "Put 10% of the cash in short-term government bonds and 90 percent in a very low-cost S&P 500 index fund. (I suggest Vanguard's.)"

That's about as passive as you can get - and this is coming from the arguably the most famous, well-respected investor of all time.

But Rickard's abrasive view of passive investing is worth a closer look.

His point comes down to the passive investor cohort essentially contributing "nothing" to the marketplace, since they're buying an index indiscriminately. No homework, no fundamental analysis, no nothing.

Since these investors are making blindly chasing the same issues, Rickards thinks that price discovery and directional impetus are suffering as a result. In fact, it's highly doubtful that an passive investor even knows what underlying stocks he's purchased in an index. After all, who can readily call to mind every issue in the S&P 500?

In short, he thinks capital is flowing to places where it shouldn't be.

But Rickards qualm with passive investing doesn't stop there.

"The danger of this situation lies in the fact that active investors are the ones who prop up the market when it's under stress," he stated. "If markets are soaring in a bubble fashion, active investors may take profits and step to the sidelines. Either way, it's the active investors who act as a brake on runaway behavior to the upside or downside."

This is a valid point - and it's true that active managers have the ability to pivot rapidly in a changing market environments, while passive managers are stuck with systematic buys and sells. One can hop in and out of individual stocks freely, while the other is at the mercy of the index.

But there's a catch.

The problem is that the vast majority of active fund managers underperform a broader index. In fact, when juxtaposed against a 15 year time horizon, 92% of active managers trail the S&P 500.

If the goal of active management is to beat the market, and the overwhelming majority that adhere to this strategy are unable to do so, then why would an investor want to partake? What good does acting as a brake do if you're going to underperform the very index you're propping up?

This doesn't seem to be fazing Rickard.

"Passive investors may be enjoying the free ride for now but they're in for a shock the next time the market breaks, as it did in 2008, 2000, 1998, 1994 and 1987," he said. "The market crash will be like a runaway train with no brakes."

He attributes this notion to forced selling by passive fund managers in order to track a declining index, which causes a cascading effect, ultimately creating a vicious feedback loop. Without active funds stepping up to buy, Rickards thinks the downward pressure will be immense.

He notes that since 2009, $2 trillion has come out of actively-managed funds, while $2.5 trillion has flowed into passive strategies. Put briefly, Rickards thinks active managers don't have enough fodder to mitigate a substantial downturn in the future - and passive strategies are to blame.

Although he has harsh words for passive investors, the truth is that the vast majority of active managers underperform.

Perhaps Rickards has the role of elephant and parasite reversed.

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