Here’s an interview on CNBC from this morning, wherein Robert Shiller argues that passive investing is a dangerous form of freeloading. Now, I’m no Nobel Prize winner in economics, but I do raise chickens, so I feel like I am fairly qualified to speak on this matter.1 Let’s see if we can hash this out.
I’ve written about this a lot, and for good reason. I work in an industry that has mastered the art of selling useless bullshit. And a big reason why that useless bullshit gets sold is because we don’t actually understand the things we’re talking about, and we instead fall for whatever marketing slogan some guy on CNBC is using. The passive versus active argument is one of the most classic examples.
To start, we have to understand some basic first principles. There is, in the aggregate, only one market cap-weighted portfolio of all outstanding financial assets. None of us replicate that portfolio perfectly because it cannot be replicated perfectly.2 So, everyone has to be at least a little bit active by deviating from this portfolio. In a strict technical sense, there is no such thing as a passive investor. Instead, we are all active to some degree. Low fee indexers are less active than stock pickers, on average. But they are both actively picking assets inside the global financial asset portfolio. So, it’s better to think of us all as active existing on a scale, from smart active (like low-cost indexing) to dumb active (day trading).
The second important understanding is that a less active investor (what Shiller is calling passive) needs a more active investor to make the underlying index work. For instance, when an index fund is purchased, its price will necessarily change relative to the underlying basket of assets. If the price of the index rises above the asset value of the underlying basket, then a market maker will sell the index and buy the underlying basket. They will buy that underlying basket from someone who is being even more active than they are as they buy the right quantities of each component. So, in order for an index to work, you need a pyramid of more active investors to help make a market in the first place.
There are two important lessons here from these first two points. Shiller is creating a non-sequitur when he ponders the idea that “everyone might index”. That is literally impossible. Second, he does not seem to appreciate the fact that a less active investor (what he calls “passive”) needs more active investors to have a…