How to Understand Passive Investing Risks

Question: Who would pay $225,000 for a bitcoin that could easily be bought on the market for $119,000? Answer: Passive index funds. Index funds perpetuate mispricing and investors are the losers. Last week, I wrote about index fund investing’s undiscussed problem: With any level of mispricing, no matter how tiny, passive funds will mechanically overweight overvalued stocks and underweight undervalued stocks, creating a drag on portfolio performance. This is the topic of my recent paper with Chris J. Brightman, CFA, “Passive Aggressive: The Risks of Passive Investing Dominance.” https://lnkd.in/dxXwwHQT As Matt Levine reminds us, the mispricing need not be tiny. Strategy, formerly MicroStrategy, is his case in point. Strategy’s main asset is 607,770 bitcoins that today are valued at $72b. Strategy has about $2b of other assets and $11b of debt. So, the net value of its assets is roughly $63b. Strategy’s value on the stock market is $120b. To be clear, Strategy’s business model is to hold bitcoin. It is not involved in any R&D that has a potential for a massive upside. Investors can hold bitcoin by buying an ETF. Investors are buying Strategy at a 90% premium to its net asset value (NAV). Huge index funds are first in line to buy Strategy when new flows come in. The index fund does not care that Strategy’s NAV is $63b. The index fund only cares about one thing: Strategy’s $120b market capitalization. In effect, passive pays $225,000 for a $119,000 bitcoin. Takeaway: Passive index funds don’t care about fundamental information. They don’t care that Strategy’s bitcoin is valued at a 90% premium. Passive only cares about one number: market cap. As such, index funds perpetuate any deviation from fundamentals. As the stock goes higher, the index flows add to the momentum, intensifying the bandwagon effect. We’ve seen this movie before. During the GameStop frenzy, the stock’s price was driven far from fundamentals, and in Jan. 2021, GameStop’s market cap was an inexplicable $33b. I am not criticizing Strategy, Michael Saylor, or the crypto space in general. My issue is with the role of passive index funds. Again, deviations from fundamental value don’t have to be small. Further, passive investing exaggerates rather than corrects mispricings as new flows buy more of the overvalued stock. This problem is likely to get worse in the future. In the next 10 years, passive could rise to 80% of all investment. That does not bode well for market efficiency. We need to do better. See research: https://lnkd.in/dxXwwHQT and videos: English: https://lnkd.in/ep5V7pum Mandarin: https://lnkd.in/emUMz5Ar French: https://lnkd.in/eGhDkUTY Spanish: https://lnkd.in/e4jv7s3z German: https://lnkd.in/eRMDM_SC Hindi: https://lnkd.in/e2vc7zMw Portuguese: https://lnkd.in/eSV-rAnM Korean: https://lnkd.in/eJkE-mhB Japanese: https://lnkd.in/eKbFA5Ym

Red flags every passive investor must identify in a sponsor. These aren’t automatic deal killers. These are the questions every operator must be prepared to answer. If they get defensive or struggle to respond, that’s your red flag. Here’s what to watch for: - They cannot provide a backup plan if “Plan A” goes sideways. - They (the team) have worked together for less than 5 years. - They assume the exit cap rate compresses in the model. - They baked-in rent growth over 2.5 percent annually. - They do not have experience in the asset class. - They provide no timeline for the business plan. - They haven’t invested any capital in the deal. - They provide vague (at best) fee disclosures. - They are not open about their past mistakes. - They have an inability to articulate risks. Bonus: - Fewer than five full-cycle deals. Ask these three questions to start a real conversation with any operator: 1. Who are the key people managing this asset day to day? 2. What specific data do you have on this submarket? 3. What risks are unique to this deal?  ↳ How are you mitigating them? P.S. These aren’t “gotchas.” They are filters for competence and clarity. A great sponsor can walk you through all of these with confidence. A mediocre one will squirm. What red flags would you add to this list?

The Hidden Risks of Index Investing: 3 Little-Known Facts Investors Must Know For investors seeking simplicity and diversification, Index funds tracking the S&P 500 have long been an easy and appealing option.  These funds are the largest components of most people's 401k plans as well as many other private accounts. However, the growing popularity of pure passive strategies have started to shift market dynamics and should give investors some pause today due to the following worries: 1. Concentration of Returns from Tech Titans 🏦 As of 2024, the top five tech companies make up about 30% of the S&P 500's market cap. Even more striking is that these tech giants have been responsible for nearly 70% of the S&P 500's total gains. This level of concentration raises concerns about the index's ability to provide the diversification it once promised. 2. Diversification Isn't What It Used to Be 🎯 A key appeal of index investing has always been diversification. Today however investors are inadvertently overexposed to tech sector-specific risks. With the advent of AI, there is potentially a high degree of disruption and regulatory risk for these large companies. 3. Valuation Worries Loom Large 📉 The already lofty valuations of tech behemoths like NVIDIA and Apple could limit how much they can continue to generate attractive returns, even after factoring in earnings growth. Given their trillion dollar valuations and index investors expectations of consistent capital appreciation, an obvious question is whether these very large behemoths can still double or triple in the upcoming years and decades. 💡 Given these dynamics, relying mainly on index funds may no longer be easy street with regard to your own financial goals or risk tolerance. A more active management approach can offer: 1. Selective Exposure: Identifying undervalued sectors and companies that the index overlooks especially in industrials, life sciences, banking etc. 2. Risk Mitigation: Proactively adjusting portfolios to navigate market volatility and sector-specific risks. 3. True Diversification: Crafting a balanced portfolio that's not overly dependent on a single sector or a handful of stocks. The investment landscape is ever changing, and your strategy should evolve with it. At Ridgewood Investments, our investment management strategies provide personalized investment solutions designed to thrive in various market conditions. The picture (created using DALL-E) depicts a boat nearly capsizing due to an imbalance caused by the over-representation of tech stocks. #Investing #ActiveManagement #Diversification #SP500 #WealthManagement #FinancialPlanning #WealthManagement #FinancialPlanning #HighNetWorth #CapitalProtection #LegacyPlanning #FinancialFreedom