Passive Investing Isn't Just Risky, It's Downright Dangerous

Passive investing is quickly overtaking stock picking as America's preferred investment strategy.

But almost no one realizes just how poisonous passive investing can be to your retirement portfolio…

Americans are piling their money into passive investments, ballooning assets committed to exchange-traded funds (ETFs) by 2,500% since 2000. There are now more than 1,500 ETFs trading on U.S. exchanges today thanks to that surging demand. Brokerage firms from Vanguard Group to TD Ameritrade are even competing for clients by offering free ETF trading.

This didn't happen by accident.

ETFs and passive funds are exploding in popularity because investors think they are safe, surefire ways to profit from a growing stock market.

That popularity is thanks in part to legends from Jack Bogle to Warren Buffett singing their praises. Just about every talking head on TV and "how-to" investing book tells investors they should be in ETFs.

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If you've paid any attention to the advice swirling around the investing world, you've almost certainly heard one of these expressions…

"You can't afford to risk your retirement savings on stocks."

"You can't beat the market, so just own ETFs instead."

"Investing in ETFs is much safer than buying individual stocks."

But I'm here to tell you this conventional wisdom isn't just dead wrong, it's actually dangerous…

ETFs Are Too Popular for Their Own Good

ETF investing owes a good bit of its popularity to the record-setting bull market.

Since the Great Recession ended in March 2009, the Dow has surged 245%.

If you put $10,000 of your retirement savings into the SPDR Dow Jones Industrial Average ETF (NYSE Arca: DIA) in March 2009, you'd be sitting on $34,447 today.

Who would argue with those results?

But with the bull market turning nine years old in August, "recency bias" leads investors to forget what it was like when markets weren't soaring.

From peak to trough, DIA plunged 50% during the Great Recession. If you put your retirement savings in a "safe" ETF at any point before the crisis, you'd have lost half your money when it hit.

And ETFs now have the potential to make the next crisis even worse.

You see, in order for ETFs to track their respective indexes, they have to buy and sell shares of the stocks in the index. When share prices of a particular stock fall, ETFs have to sell some shares to maintain their balance.

But the biggest problem here, and the one we haven't experienced in nearly a decade, is ETF fund managers will have to find buyers for these stocks when the market falls.

And if no buyers exist for the stocks – which could easily happen for illiquid stocks during a sell-off – the funds' values could crater…

Today, 42% of all U.S. stock fund assets are held in passive funds. That compares to a mere 12% in 2000. So we simply won't know how drastic this effect is until the next bear market.

But it gets even worse for passive investors, and it's the dirty little secret the Jack Bogles of the world would prefer to keep hidden…

The Fatal Flaw of Passive Investing

While ETFs will provide you no cover during the next market pullback, and could even make it worse, there's an even more damning problem behind their popularity.

As Howard Marks, the co-founder and chairman of Oaktree Capital Management, told his clients, "active investors do the heavy lifting of security analysis and pricing, and passive investors freeload by holding portfolios determined entirely by the active investors' decisions."

In short, ETFs merely mimic the market, and market prices are set by what active investors are willing to pay for stocks.

And while passive investors have been free riding on the research and analysis of active investors, that party is quickly coming to an end.

As Marks explains, once the majority of stocks are managed passively, "prices will be freer to diverge from 'fair,' and bargains (and over-pricings) should become more commonplace."

In other words, ETFs can distort the prices of stocks they hold "for reasons other than fundamental ones," according to Marks

I hope you caught that, because it could prove ruinous to your investing portfolio…

In case you didn't, Money Morning Special Situation Strategist Tim Melvin distilled it down the best:

"Make no mistake: if stocks are appreciating to high valuations for any reasons 'other than fundamental ones,' it's a surefire sign of a bad investment."

That means you could be pouring your hard-earned money into bad, overpriced investments as ETFs distort market prices. And the conventional wisdom on Wall Street is telling you it's a great idea!

Fortunately, it's also creating an opportunity to make an absolute killing off the people who are unwittingly fueling the ETF bubble…

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