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The Danger of Passive Funds

In recent years, there has been a sharp move from actively managed funds to passively managed funds. Actively managed funds are investment funds that are managed based on the decision of a fund manager. The fund can be invested in any type of asset class, but the buying decision would lie with the fund manager.

On the other hand, passively managed funds are investment funds that invest in a benchmark index and just try to track the performance of the index. The fund manager would not make any individual investment decision for the fund.

In 2016, more than US$264 billion flowed out of active funds while more than US$236 billion flowed into passive funds. The trend is accelerating. More and more people are turning to passively managed funds which just track the performance of indices, rather than betting on active funds.

However, this seismic move into passive funds might not be risk-free.

In a passive fund, there is no one in charge of the buying decisions. This means that as long as there is more cash coming into the fund, it will continue to buy the stocks in its benchmark index, regardless of valuation or fundamentals of these companies.

This also means that the buying and selling decision would lie with the fund investors, as they invest more money into the fund, the fund would be buying more. If they withdraw cash from the fund, the fund would have to sell.

This might lead to a more volatile market swing during times of greed and panic. Investors might rush to buy more of these passive funds during a bull market, creating an asset bubble. And when the market turns, investors might rush to sell off these passive funds, creating a panic sell down in the market. This could cause the market to peak higher and fall sharper during the bull and bear markets.

However, when there is a crisis, there will be an opportunity. For investors who can keep their cool during a market panic, these huge swings created by passive funds might be a great buying opportunity for these value investors.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.