In the past, investors who wanted to own shares in a fund typically purchased actively managed mutual funds. Fund managers picked stocks and charged investors large fees for their services.
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Investors are now primarily flocking to passively managed exchange-traded funds (ETFs). Many of these simply mimic major stock indexes such as the S&P 500 and Russell 2000.
Never one to hold back, Elon Musk has repeatedly attacked passive investment funds. He said in December 2023: At the end of the day, someone has to actually make an active decision. Passive investors are riding on the decisions of active investors. ”
So what is Elon interested in passive investment funds?
market distortion
While Elon is expressing his personal opinion in his critique of passive investing (more on that later), the broader problem for the market is that investors are lemming blindly into the biggest stocks. This is due to the effect.
Stock indexes are weighted by market capitalization. The top five stocks in the S&P 500 account for nearly a quarter of the total index. Microsoft (7.09%), Apple (5.65%), NVIDIA (5.06%), Amazon (3.74%), and Meta (2.42%).
As investors move money from individual stocks and managed mutual funds to passive index funds, they end up spending a disproportionate amount of money in large companies. This creates a feedback loop in which as a company grows, it attracts more investment capital, which causes the stock price to rise even more, making the company even bigger.
Read more: 10 valuable stocks that could become the next Apple or Amazon
Establishment of giant companies
Capitalism works because there is competition. Even as Goliath, Inc. makes its product line obsolete, David LLC innovates to offer something new and improved, giving Goliath a pat on its back.
The constant threat of disruption from nimble new entrants forces large companies to constantly research, improve, innovate, lower prices, and otherwise better serve their customers.
But what happens if robo-advisors put all their money into big companies without thinking?
They benefit from cheap money and high stock prices. This gives you an additional competitive advantage against new entrants who want to challenge you and make you accountable to your customers.
Passive investing represents a type of financial groupthink. All our money goes to the same big companies and gets very little attention.
Corporate governance
Publicly traded companies are owned by the public, especially their shareholders.
But as passive funds eat up more market share, they control more ownership of these public companies. They potentially wield enormous voting power.
Elon was so concerned about this that he compared one such index fund advisory firm, Institutional Shareholder Services (ISS), to ISIS. Of course, he doesn’t want outside investors telling him how to run Tesla. In doing so, he shortens his leash.
But just because Musk feels personally uncomfortable doesn’t mean he’s wrong about the market’s broader risks.
Perhaps we don’t want corporate governance power to be too concentrated in fund advisory companies. Maybe we don’t want so much of our collective money concentrated at the top of a few huge companies.
If you share Elon’s concerns, consider investing in an equal-weighted fund that spreads your money evenly across all companies, rather than weighting them by market capitalization. Also, consider investing more in small- and mid-cap funds to increase your exposure to the other side of the market.
Or you can always go back to actively managed mutual funds and skip the algorithm altogether.
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This article originally appeared on GOBankingRates.com: Elon Musk’s Warning: Is Your Passive Investing Strategy Aligned with the Future?
