Where is passive investing taking us?

In market speak, if passive ETFs are akin to a dog chasing its tail, for how long can it chase it? And what happens if the dog catches it?

The surging popularity of passive ETFs has raised questions for market strategists about the limits of passive ETFs and how much more they can grow.

Ten years ago, there were fewer than 100 passive investing products on the TSX and five ETF providers. Now, there 465 ETFs and 19 providers, says Nicholas Thadaney, head of global equity capital markets at TMX Group, who spoke last week at financial advisor industry conference in Toronto. And in the U.S., the trend is bigger. As of last summer, ETFs had accounted for 42% of each dollar traded on U.S. exchanges.

Ten years ago, sophisticated investors believed in passive investing, but today, Yves Choueifaty sees them moving to smart beta.

Read: How to invest in Canadian equities

“When retail is doing passive, it means [to] beware passive,” said Choueifaty, chief executive of the Paris-based asset manager TOBAM. A proponent of smart beta strategies, he sees more investors exploring them. “We are witnessing today the last moment of passive,” he said.

“Now, they understand that maybe the real quest is not for alpha, but the real quest is for a better beta,” he told Advisor.ca at the conference. “Most sophisticated people have understood that it doesn’t makes sense not to manage money, and passive is the absence of management.”

It’s active managers who collectively set prices for assets, he said, and when markets are most efficient, the markets can’t be forecasted.

Critics of smart beta say such products can be overpriced and that they do not necessarily outperform net of fees.

Read: Less efficient markets call for active management, says CFA

Timothy Cohen, chief investment officer of Fidelity Investments, said one risk of passive investing is that it generates market momentum, at times contributing to asset bubbles. Index funds had big stakes in the tech-companies during the dot-com boom, he noted, at a time when active managers saw the companies as overvalued and took underweight positions.

“Index funds owned 30% [or] 35% in the U.S. weighting in technology stocks, and many of them didn’t have earnings,” Cohen said. “Fundamental, active investors couldn’t make sense of those valuations.”

When could the level of ETFs be dangerous? More serious volatility could be an indicator, Cohen said.

Sheryl King, advisor to BoC Governor Stephen Poloz, said the bank is watching for any issues with ETF liquidity if asset values fall. Synthetic ETFs also can expose an ETF asset class to counterparty risk, she said.

“At this point, we don’t think it is a big source of vulnerability for Canada, but it’s something that we’re going to continue to monitor,” King said. “Certainly, some of the questions that have been raised across this table are something that I might actually come back to the bank, and have some conversations and do some debriefing about.”

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