What we refer to as passive investments have become more and more popular over the last few decades. These are things like index funds, where you’re basically investing in all the companies of, say, the S&P 500. This has been a generally easy, cheap and profitable way to invest your money. The thinking goes that people doing it this way don’t really move the market — they’re more along for the ride based on the ways that more active investors are buying and selling.

But is passive investing becoming so big that it’s no longer passive? And what dangers lie within?

These are questions that author and journalist Andrew Lipstein set out to answer. He’s got a piece in the latest Harper’s Magazine with the title “What goes up: Does the rise of index funds spell catastrophe?” He spoke with “Marketplace Morning Report” host David Brancaccio about it, and the following is an edited transcript of their conversation.

David Brancaccio: I mean, you’re a writer with a young family. You’d like to provide. So you alarm yourself by spending quality time with one of the most passionate voices who likes to make the case that passive investing, buying index funds, it’s all going to fall apart someday?

Andrew Lipstein: Yeah, I mean, I’m a big fan of sort of scaring yourself silly. And I could think of no better thing to do as a passive investor myself. As I say in the piece, the bulk of my family’s savings is in index funds — long-term investing, passive investing. So I visited Michael Green, who’s one of the biggest passive investing doomsayers around. The purpose of visiting Michael Green and the purpose of the piece is to really dislodge myself and dislodge readers from their inherited assumptions about the market, about investing, and even what money is.

Brancaccio: So, just a little more about Michael Green, whom you consulted. He’s a fund manager who once made a quarter of a billion dollars on a trade on behalf of Peter Thiel, the tech tycoon. But he talks about this a lot: When you buy, let’s say, the whole S&P 500 — which, by the way, is a cheap thing to do, because you don’t pay the higher fees for active fund management — he thinks that that has an inherent, what, instability?

Lipstein: Well, there’s a few aspects. I think at the base of it, it’s sort of a contrivance, it’s sort of changing what it means to invest. So, as many Americans do, if you have some extra savings at the end of the month, or you have a 401(k), you are just automatically putting money into what we call the market. And of course, there’s no such thing as the market. There are actually funds, there are ETFs and indices that help you do that. And what happens is the function of the price of those funds — really all that matters is whether you have money leftover on the passive investing side of it. This is historically not what the price of a stock or an index is. It is sort of a real-time estimation, based on investors, of how much the stocks in that fund are worth. But yeah, Michael Green is a super interesting guy. And he has made a lot of money on theories about the market. He has managed both Peter Thiel’s family office and the funds seeded by George Soros. And it’s sort of hard to think of two more distant poles in the world of the mega wealthy.

Brancaccio: So, Mr. Green is not making the case that I sometimes hear — that these giant index fund managers have all this clout as huge shareholders in every company, so that there’s like an antitrust issue. That’s not his beef?

Lipstein: Yeah, exactly. So that issue is basically called common ownership. And that’s — you know, what would happen if a company like Blackrock or Vanguard or State Street, known together as the big three, controlled most of competing firms? And, basically, as shareholders, could decide the future of competing firms? That I think is actually the most talked about issue as far as passive investing goes.

But what Michael Green is concerned about is — what is actually happening to the market as far as passive investing rises in influence? Historically, passive investing has been seen as sort of a measure of the market. They say, “Active investors decide what the prices are. And then we capture the state of the market in passive funds.” But what we’ve seen over the past 15 or 20 years is really a rapid, almost dizzying, rise in passive investing. Estimates vary between something like 15% and 35%, of how much of the market it’s captured. But it’s moving so fast, that it’s very easy to see in the next 5, 10 or 15 years it being one of the most major players and actually deciding prices in the market and not just sort of measuring the market.

Brancaccio: But, if we’re to get to this notion that I think Mr. Green has that it’s possibly a bubble, passive investing, that could pop, explain to me this idea that the industry is getting so big it would create its own gravity. 

Lipstein: Exactly, yeah. So the bird’s eye view is that, if we think about on the left side of the spectrum, there is the price of the market is just the valuations of the companies and what active investors think they are. And on the right side is basically just an investment vehicle for passive investors, who don’t really care what the companies are worth. They just want some place to put their savings and have it grow. As we move from the left side of that spectrum to the right, the prices of stocks have less to do with what active investors — either using qualitative or quantitative analysis — think that those companies are worth and more just, this is a function of, do we have money leftover? And what you’re asking is, how can this be catastrophic? Well, there’s gonna come a time — whether this is because of a generational shift, or regulatory change, or just a new paradigm at play — where money starts to come out of that market. Right now — because of the function of the American population and how they’re aging and how they’re investing — we basically have seen only more money put into passive investing. But if we do hit an apex, what Michael Green is especially worried about is, what happens then?

And basically, there’s two factors of a passive investing market that he’s most concerned with. One is in elasticity, and the other is correlation. So what we find in a passive market is that things can be very inelastic — meaning small shifts in prices can result in bigger shifts in volatility. If you imagine, you’re in a meeting with colleagues, and there are 10 people in the room, and two of them are passive, meaning they don’t really have opinions and they’ll just go with what other people say, and eight of them are active — well, there’s going to be a lively debate. But as more of the room is full of passive employees, passive colleagues — let’s say there are now two active employees and eight passive — the only two people who are going to have a say in the room are the two active workers, and the other eight are just going to swing sides, and you’re going to see a lot more jerky motions in the market, and it’s going to feel a lot less fluid. The other aspect he cites of the passive market is correlation. And this is something you know, for such an anodyne word, it really is very alarming to money managers, to economists. Because whenever there’s been a huge problem in the market, you can always draw a line between that sort of volatility and correlation. If everything is moving in lockstep, that can result in some serious swings. 

Brancaccio: And then, what could change the paradigm? I suppose like if we had a shorter term stock market crash, people could fall out of love with investing in general. And then you could have these outflows from passive funds as well as active. The other thing, of course, is demographics, right? The population is getting older — we’re all getting older — but a lot of us are getting older. And we might want to start pulling our money out to live on. Maybe that is worrying Mr. Green?

Lipstein: Yeah, he’s, I think, very careful to not make a direct prediction as to what will disrupt the paradigm — when or how we’ll hit our apex. But I do think it’s really useful for investors to think about the fact that at any given time, we are in a paradigm. Index funds are not something that have been with us for long. They feel like the most entrenched way of investing. But if you go back even 50 years, this is not how we were investing. And so I think it’d be irresponsible to assume that just because it feels like the safest option, that this is what we’ll be doing in 50 years, or even 25 or 20.

Brancaccio: People who think that passive investing is a sure bet, right, that’s a classic investor mistake. We do have stock market crashes. Nothing is guaranteed. I’m always reminding people that if you need your money, like you have a kid going to college in a year or two, it shouldn’t be in the stock market. Are we forgetting that?

Lipstein: Yeah. And a lot of people  felt this in 2020. I know, personally, some families who were retiring soon, got scared, pulled money out of the market near near its low and suffered from that. There’s the most common footnote in sort of any financial literature and marketing that says, “Past performance does not guarantee future results.” The S&P 500 is currently basically the highest it’s ever been. We have seen first-world, functioning markets over the course of decades only decline, you know, probably the most cited example is Japan in the ‘90s. I would just want to warn every investor not to assume that just because something has happened in the past it’s going to continue to do so.

Brancaccio: You approached the company that essentially created low-cost, passive investing — Vanguard. What do they say about this concern that it might someday fall in on itself?

Lipstein: You know, it’s funny, because nobody likes active investors more than passive investors. And in my conversation with Rodney Comegys, who’s the global head of Vanguard’s Equity Index Group, every time I brought up passive investing increasing in size and controlling more of the market, he continually talked about active investors. And it’s kind of one of these weird relationships where, in order for passive investing to make a case for itself, it has to really be convincing about the importance and almost the timelessness of active investors. Because they know that a market controlled strictly by passive investors is a really scary market. Because that means that prices are really just determined on, “Do people have money leftover that they want to invest in the market?” And not some sort of actual market efficiency, where investors are deciding the true price of things.

Brancaccio: Let’s just land on that for a second. The idea is, when you do passive investing by the entire index, you might be rewarding companies that are doing a bad job of it. Where an active investment approach would have the — highly paid, often — fund manager trying to pick the stocks where the price is weirdly low and expected to go higher. It brings an efficiency to capitalism that, certainly, purists like. You’re saying even the passive investment mavens like those at Vanguard appreciate what the active fund managers are doing.

Lipstein: Yeah, I would say, appreciate — rely on, for their very lifeblood. If you’re an active investor, and you’re watching a certain stock go up and up and up, you might bet against it because you might think the market is getting ahead of itself. And you don’t think the actual core value of the company has changed. So a rise in price might lead you to sell, which actually helps decrease the price and keep the market efficient. In index funds, we actually see the exact opposite logic, basically. Which is that as a company’s price increases — and this doesn’t mean that they are overpriced or expensive — but their prices increase, they will receive a bigger share of every incremental dollar invested in a fund that it’s a part of, assuming that fund is market cap-weighted, as most are. And this, you know, it’s really worrying to people like Michael Green, especially because it affects their performance. As I note in the piece, in the past 20 or so years, I think only 7% of active investors have outperformed the S&P 500. And a lot of active investors are currently betting against it. The question is, “Will passive investing gain a gravity of its own, and sort of detach itself from the true value of the companies that the stocks in its index supposedly represent? And basically prove them all wrong?” And I think that’s the biggest question ahead of us in the next five or 10 years.

Brancaccio: You are aware that often highly paid, active fund managers smarting from their records of charging more and delivering less for their clients are probably super pumped to see this Harper’s piece come out casting shade on the cheap, but often effective, investment strategy [of] buying an index? Do you worry about how you’re cheering up active fund managers?

Lipstein: Well, I want to be clear: I’m not telling readers to head straight to their, you know, most well-heeled active investor and pay the highest fee they can. I mean, there’s a reason why passive investing has been so popular. I think the fee for SPY — which is State Street’s S&P 500 ETF — I think the fee is something like 0.04%. And you will pay almost 20 times that to have an active manager manage your money. I mean, in order for that to make sense, you really have to expect bigger returns, and we haven’t seen that in the past. I am not changing my personal investment strategy. I’m not fleeing to an active investor. And in no way am I telling a reader to do that. What I hope the piece does is shake them out of any assumptions they’ve had about the market and rethink what investing is.

Brancaccio: I mean, that says a lot, Andrew, right? That we need to continually remind people that the stock market carries with it risk  — sometimes very intense risk. And that has not been outlawed by passive investing or anybody else.

Lipstein: No, it hasn’t. And most Americans are not looking to actively invest. They want a safe option. But the truth is — and this is probably, you know, the scary undercurrent throughout the article in investing — there never is a safe option. You’re always best off diversifying, you’re always best off investing in goods that you can actually use, such as property. There’s no such thing as putting your money into something and it will be there in 10 or 15 years with a positive rate of return. There’s never a guaranteed product that has done that.