Is There a Dark Cloud Hanging Above a Passive Index Fund Investing Approach?

Most, although not all, of the robo-advisors practice some form of a passive index fund investing approach. This type of investing is based upon widely accepted and well-researched investment practice that demonstrates that it’s extremely difficult for actively managed funds to beat the performance of the major market indexes such as the S&P 500 and others.

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Does that mean the robo-advisors are doomed if index fund investing’s success waivers?

What If Everyone Started Investing in Index Funds?

How would this phenomenon impact the robo-advisors? Many of them practice an index fund investing approach. Would this mean that most robo-advisors are doomed?

The argument that if everyone practiced an index fund investing approach then markets would cease to be efficient and their alleged advantage over active management strategies would go away has been around a long time.

I remember back in the early 2000s when I was in my MBA program, this very conversation came up in one of my investing classes.

If this premise is true, and the majority of rob-advisors’ platforms are based on a passive index fund investing approach. Then what might happen to the industry? Now bear with me a moment. It seems a bit silly that I’m questioning the longevity of what is basically an industry in its infancy.

Yet, it’s important to understand all facets of an investment approach, in order to be an informed consumer.

Are Robo-Advisors at Risk of Failure Due to an Impending Crash of the Passive Index Fund Investing Trend?

First let’s hear what Charlie Munger, Warren Buffett’s long-time business partner, has to say.

“Index funds will be permanent owners who can never sell. That will give them power they are not likely to use well.” ~from “A Billionaire’s Warning on Index Funds” by Jordan Wathen of the Motley Fool at CNN Money.

Then there’s Mario Gabelli. He's a legendary value investor (as a side note, I invested in a Gabelli fund for many years), who contends that index funds weaken corporate governance. He goes on to say that index funds typically don’t question corporate management’s activities, which leads to governance that may not be in the best interests of the shareholders.

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To substantiate this allegation, it made the headlines in 2013 when a Vanguard index fund manager voted against directors at Hewlett Packard.

From a purely statistical viewpoint, when everyone is buying the same stocks, it would be impossible for those stocks to outperform as there would be no counter party on the other side with which to trade and they would necessarily have to underperform.

Most, although not all, of the robo-advisors practice some form of a passive index fund investing approach.

So does this mean that index funds are doomed to underperform and that the robo-advisory industry has jumped on to a sinking ship?

We don’t think that robo-advisors are doomed.

In spite of their seeming expansive popularity, index funds represent less than 1 in every 5 investment dollars. There still exists thousands of actively managed mutual and exchange-traded funds. Additionally, there’s no shortfall of investors looking to try their hand at stock-picking.

You don’t need to look any further than the combined DIY/robo-advisory platform Motif to see the multitudes of folks that want to try their hand at stock selection.

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