December 2018 | Retail Version

We believe that 4Q 2018 provided insight as to what might happen to investors exposed to a potential passive investing bubble in the event of more prolonged market turmoil. The S&P 500 TR Index declined by -13.52%, while the FAANG stocks dropped by an average of -23.41%. In fact, some of the top contributing stocks as of June 30th ended the year as some of the bottom contributing stocks.

In our July 2018 piece, “The Passive Investing Bubble,” we provided evidence to suggest the potential formation of a passive investing bubble. The thesis was as investments into capitalization-weighted indexes increase, the largest stocks that performed the best tended to get a disproportionately large allocation, creating a self-reinforcing cycle of these stocks performing well. In the event of market turmoil, investors with heavy exposure to certain stocks may experience significant losses. We cautioned that investors should be concerned about exposure to FAANG stocks given their allocations in passive strategies and their potential downside risk.

In the face of market volatility, it is important to be dynamic and adaptable to ever-changing market conditions. Being constrained to certain sectors and Morningstar categories limits the opportunity for outperformance. We believe that the recent return of market volatility leaves a lot of space for active managers to add value, particularly if market conditions deteriorate and assets flee passive strategies.

Chart represents the percentage of assets in active and passive mutual funds and ETFs since 2008. 2018 percentage is as of 11/30/2018. Source: Morningstar Inc.
*2019 projections are based on annual average growth rate from 2008 to 2018.