Once upon a time, investors who wanted to own shares in a fund typically bought into actively managed mutual funds. A fund manager picked stocks — and charged investors handsomely for their services.
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Today, investors largely flock to passively managed exchange-traded funds (ETFs). Many of these simply mimic major stock indexes like the S&P 500 or the Russell 2000.
Never one to hold back, Elon Musk has blasted passive investment funds on numerous occasions. He put it like this in December 2023: “The percentage of the market that is passive is simply too great at this point. At the end of the day, somebody actually has to make an active decision. The passive investors are riding on the decision of the active investors.”
So what’s Elon’s beef with passive investment funds?
Market Distortions
While Elon has more personal fish to fry in his diatribes against passive investments (more on those later), the broader problem for the market comes from a lemming effect of investors just mindlessly piling into the largest stocks.
Stock indexes are weighted by market capitalization. The top five stocks in the S&P 500 account for nearly a quarter of the entire index’s value: Microsoft (7.09%), Apple (5.65%), Nvidia (5.06%), Amazon (3.74%) and Meta (2.42%).
As investors move their money from individual stocks or managed mutual funds into passive index funds, it throws a disproportionate amount at the largest corporations. It creates a feedback loop: companies attract more investment dollars because they grow, driving up their stock price further, causing them to get even bigger.
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Entrenching Giant Corporations
Capitalism works because of competition. If Goliath, Inc. lets its product line get stale, David LLC innovates to provide something new and improved and knocks Goliath onto his back.
That constant threat of disruption from nimble newcomers forces huge companies to constantly research, improve, innovate, lower pricing and otherwise better serve their customers.
But what happens when robo-advisors just unthinkingly throw all their money at the largest companies?
They get the benefit of cheap money and inflated stock prices. That gives them even more of a competitive advantage over newcomers who try to challenge them and hold them accountable to their customers.
Passive investments represent a kind of financial groupthink. All of our money flows into the same large corporations, with little attention paid.
Corporate Governance
Publicly traded companies are owned by the public — specifically, their shareholders.
As passive funds eat up more market share, however, they control more ownership of these public companies. They could potentially wield enormous voting power.
Elon worries about this so much that he compared one such index fund advisory, Institutional Shareholder Services (ISS), to the Islamic State group ISIS. Of course, he doesn’t want outside investors telling him how to run Tesla — it leaves him with a shorter leash.
But just because it chafes him personally doesn’t mean Musk is wrong about the broader risk in the market.
Maybe we don’t want too much corporate governance power concentrated in the hands of fund advisory companies. Maybe we don’t want so much of our collective money concentrated at the top with a few mega-corporations.
If you share Elon’s concerns, consider investing in equal-weighted funds that spread your money evenly across all companies rather than weighting by market cap. Also consider investing more in small- and mid-cap funds for more exposure to the other end of the market.
Or you could always go back to actively managed mutual funds, and skip the algorithms 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?