If there’s one thing that’s characterised the market in the last decade, it’s a fundamental shift to passive investment strategies — whether that’s a bad or a good thing depends on your perspective.

One thing that’s not in dispute: passive investment strategies are hot right now.

There are several numbers floating around which demonstrate the trend, but by some estimates the share of assets in passive funds today ranges between 33 and 47 percent — which is up from between 13 to 24 percent in 2007.

The growth comes down to a range of factors: including a perception that handing fees over to an active manager when better net returns could be realised from tracking an index just doesn’t make sense.

The rising number of ‘robo advisors’ now on the market as algorithmic trading becomes more popular is testament to that.

But despite its popularity (or maybe because of it) there are downsides to passive investing.

Next week we’ll make the case for passive investing (and it’s an equally compelling case) — but let’s take a look at a few downside risks.

As always, content on Star Investing is not an investment recommendation.

6 reasons why passive management can be a bad thing

1. You can’t beat the market if you’re set up to track the market

One of the cornerstone products under a passive investment strategy is buying up exchange traded fund (ETF) shares.

They’re an instrument designed to track a particular basket of stocks, such as the ever-popular ASX-200 ETFs which includes Blackrock’s iShares offering (ASX:IOZ).

For a long-term investor, tracking the ASX 200 would have yielded good returns – it is up 72 percent over the past ten years.

But iShares hasn’t outperformed the index it’s tracking for the simple reason that it’s not set up to beat it – it’s set up to track it.

Data from Google Finance

 

2. You could be missing out on other sectors

Unless you’re a diversified index trader, you’re more than likely missing out on sectors that may generate a better return over a particular time frame.

Taking the ASX 200 as an example — it’s weighted towards banks and miners. But you may be seeing more value being created in biotech and health.

While the ASX 200 may have some health and biotech stocks in it (12 to be precise), it’s by nature missing out on the full weight of that sector.

3. The robo-herd

A lot of the allure of passive management is that you don’t have to pay as much in management fees, which can chew up a chunk of your return.

This becomes doubly apparent with the rise of ETFs based on algorithmic trading (or the robo-advisor).

This is simply an algorithm designed to track an index — and several market-watchers are worried that algorithmic trading is increasing volatility in the market.

A lot of ETF investment options will have stop-loss orders baked into the math, so if the index it’s tracking goes below a certain level it will immediately start selling to protect holders — adding to the downside.

So movements downward (and upward) are more pronounced as a massive volume of sell or buy orders flood the market — ultimately increasing volatility.

4. It’s hard to place a bet on the future if you’re tracking an index

Some of the more valuable trades are made as a result of building up a position in an unloved company or sector — only for it to go up in the future as the fundamentals become apparent.

For example, if you placed a bet on Facebook in 2015 at $78, that investment would be sitting at $170 today (at the time of writing).

READ: Has FAANG fury had an effect?

If you’re tracking a broader tech market, you may have missed out on that growth. Meanwhile, junior resource exploration companies may offer opportunities for multiples on your original investment.

But it’s highly unlikely that you’d build a position in that company if you’re passively investing (unless you’re specifically in a small cap ETF).

5. Passive investing may reward poor companies and punish the good ones

The thing about a lot of passive investment is that it’s essentially set up to track a basket of products, whether those are in an index ETF or otherwise.

It means that companies which have been designated to be in a certain index are ‘brought along for the ride’, whether it deserves it or not.

For example, a gold company is selected to be in a gold equities index. As the price of gold rises, so does the whole index, as one of the key buying triggers in the algorithm is the price of gold.

What if said gold company is just a bad company — with bad cash management and a disinterested board? In this example, it’s being rewarded for simply being a gold company rather than traded against its fundamentals.

As more traders set up to trade in this fashion, this effect becomes more pronounced, and the greater the company with poor management is rewarded.

6. It’s just not fun

Just giving a robot your money and sitting back and relaxing may be ultimately rewarding, but where’s the smarts in that? And where’s the thrill?

There’s a thrill in doing deep-dive research into a company, getting to know its prospects and the projects its working on and investing accordingly.

Investing for many can be very emotive – investor become attached to companies and their goals. The ride the highs and lows and stick with it through thick and thin, ultimately hoping to be rewarded at the end of it all.

Yes, it’s inherently more risky – but can also be far more rewarding.

Active investment opens a whole new world of involvement with your investment — and that certainly appeals to some people.

Others may not see the value in the hassle, but others see a thrill in the hunt for value — and that’s what you lose with passive investment.

This content does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.