As passive investing continues to gain popularity, concerns have materialized about some unintended consequences, according to a recent article inMorningstar.

The article outlines an interview with Morningstar’s director of passive strategies, Alex Bryan, who shares his insights. Here are some highlights:

·      One of the concerns, Bryan explains, is that as more people index, fewer become “dedicated to doing fundamental analysis on individual securities” and more end up buying and selling “the entire market.”  In that scenario, if everyone pulls money out of the market, it could cause more mispricing than if you had active pickers doing analysis on a case by case basis.

·      If the market is not efficiently priced, Bryan says, “then you could end up owning big stakes and stocks that are overvalued.” Bryan points out, however, that since index funds represent a smaller percentage of trade volume than of total asset ownership, and “active managers are still driving most of the price discovery that’s happening,” some of these concerns may be overblown.

·      Another concern arises from market pricing pressures that arise when indexes add or remove stocks from their portfolios. Bryan explains that when stocks are removed from an index, those that are tracking that index must “sell those securities at about the same time regardless of the price they get,” which causes prices to drop. The converse is true as well, he says, which means that index investors are “getting the less favorable prices because they’re not able to buy those newly added securities until after the price goes up or sell until after the prices have gone down.” He suggests the following two solutions:

o  Own a total market index so that “you’re kind of on both sides of these trades, and it’s a wash.”

o  Look for indexes that are taking steps to mitigate unnecessary (and potentially costly) turnover.

·      A third concern is that excessive indexing could cause businesses to be less competitive. Bryan explains that since index investors own all the companies in the market, they “don’t necessarily have the same incentive to pressure managers to maximize the value of any single company. They may not be as concerned about one firm winning at the expense of another because they want to see all the firms in an industry win.” But Bryan contends that the argument is not well-founded: “I think managers of most companies are heavily incentivized to maximize…the value of their own company.”