I don't think the idea that the world (or, millennials?) are moving towards low cost passive investment needs much explanation. It's a given. What's interesting to me but I never see discussed is what happens when this trend is taken to its natural conclusion with everyone - or at least a major bulk of invested wealth - becomes passive.
Super Brief Primer on How Stocks are Priced
Imagine there's a stock and a universe of 10 investors. To make it easy, imagine right now all 10 own 10% each of the available shares. At the start of the day, the stock is worth (ie was last traded at) $7. All 10 investors actively try to determine what the stock is "really worth" (whatever that means) Imagine half of the investors decide it's worth 8 dollars and the other half decides it's worth $9. The guys who think it's worth 9 will bid up the price until it's high enough (say, $8.05) to compel the other half to sell to them.
The big point here is that price movements occur from divergence of opinion - the reason the stock moved from $7 to $8.05 is that some guys thought it was not worth more than 8 while other were ready to pay 9.
What happens if there's no difference of opinion? If the stock is at $7 and all 10 investors decide it's "really worth" (whatever that means!) $4 - no trading will occur! They would each be happy to sell it for any amount above $4, but none of them are going to buy it for more than $4! In fact, the only way that any trading will occur in this situation is if at least one of the investors needs to sell stock to get cash - in that case he'll have to sell for under $4 to induce any of the other 9 to buy. Alternatively, if one of the investors was somehow compelled (more on that later) to buy this stock - they'd end up paying a over $4 to get it - even though it's more than it's worth...
So the big idea here is that in the absence of divergent opinion, supply and demand for cash redemption/investment drives the price.
How could things go wrong? Imagine 9 guys know that the 10th will sell his shares because he needs cash. If they all think the stock is worth $4 - are they going to be good citizens and buy the shares form him at $3.99? My bet is they are going to refuse to trade at that price and only buy from him at like $0.01 - the information that he must sell is powerful. Similarly if they all knew that one guy needed to buy, they'd force him to buy it well above the "real worth" of $4.
Luckily, the stock market is composed of thousands of stocks and millions of investors, so no one can predict that there will be an absolute supply or demand for a stock that they can take advantage of.
How Passive Investment Works - Two Paragraph Version!
So remember that first example where some guys decided the stock was worth $8 and others decided it's worth $9? One half of them was wrong - if the stock ends up at $15 in a year, the buyers are happy and the sellers are kicking themselves. If the stock ends up at $2, the sellers are happy with their decision and the buyers are ruined. Since the stock market is unpredictable and random (that's a different topic altogether but I feel confident in this statement for what its worth) - a trader has a 50/50 shot of being "right" or "wrong" on any given trade.
But! The process of determining what the stock is worth is costly and time consuming! Think of all that research, time spent reading statements, investor calls, and following the CEO on Twitter. If the cost of research averages out to $1 per share, when you buy a stock at $10 and it goes to $15, you only make $4 (but you consider that $1 well spent) but when you buy at $10 and it goes to $5, you lost $6!
So what happens is... one of the investors decide they are sick of paying $1 just to be "wrong" 50% of the time. So instead, they don't bother figuring out what the stock is worth, they just trade at whatever price is there based on the research of the other 9 investors. So they are still wrong 50% of the time, but they make $5 (not $4) when their stock goes from $10 to $15, and they lose $5 (not $6!) when it goes from $10 to 5. That's passive investment in a nutshell!
How It All Goes Badly
The passive investor guy is kind of like a little car drafting behind a large truck. The truck isn't really affected, and the car's driver pays a lot less for the gas. The only problem is, he has to follow the truck to its destination rather than figuring out where he wants to be, but he's fine with that since he knows he'd on average make the same choices as the truck.
But in this case, passive investment has significant impact on the active. For one, it attracts a lot more funds, since individuals see that they can get the same returns as the active guys at a lower cost. This deprives the active guys of "assent under management" (AUM) - on which they charge fees that pay for all the hard research they do. It also puts pressure on them to lower their fees - a double whammy.
So over time, more and more of the 10 investors in our scenario become passive. What happens when most of them are?
Well, for one, the "quality" of prices goes down a lot. Whereas in the beginning, we had 10 people doing their best to figure out the "correct" price of the stock, we may be in a situation where 1 or 2 guys are trying to do that - with fewer resources due to shrinking AUM and fees, while the other 8 are blindly accepting whatever price is out there. No matter how you slice it - 10 people doing their best research were more likely, in aggregate, to come up with the right price compared to 2 resource strapped people...
What's more, the price becomes a lot more driven by cash flows than fundamentals. If the two guys are doing active research and decide the stock is terrible, but the other 8 have incoming cash that they must invest in this stock because its part of the index and there was an inflow of say retirement investments, guess what - there's more buying than selling! So even though fundamental research says the stock should go down, the stock goes up driven by blind demand.
This has a side effect of completely killing research-driven investing. What's the point of doing research to determine which stocks are good or bad, when their prices will be driven by the blind demand (or supply) based on cash flows of the passive investors? Even if I am right in what the price "should" be there's no market mechanism in this scenario that will make the it get there.
Remember - it's the difference of opinion that drives stock prices in a correctly functioning market. If there's no difference because there are no opinions, prices are going to be driven by the need to buy and sell.
So here's where it gets really rough. Remember the example where 9 traders knew that 1 had to buy (or sell) and they gouged him? The same happens here. If I own a stock that's a part of an index, and I know that people are overall saving money and investing it in passive managers (which I can know easily) - they why the heck would I sell my stock to the passive managers today when I know they will need it and continue needing it more and more each time they get cash to invest? I will hold to this stock or only sell it at a completely ridiculous price - which I can do since I know my counterpart must trade.
Trading depends on there being a buyer and a seller - if everyone follows the same index passively, and a stock is part of the index, everyone will want to buy that stock at the same time (assuming there are general inflows into the market) or everyone will want to sell it at the same time (if there are systemic outflows.) So this means that stock prices will rise very rapidly during inflow times, and drop precariously when there are outflows.
For an investor in a passive fund that means buying when everyone's buying (ie, high) and selling when everyone's selling (ie, low) which is not how you make money generally.
Finally, there's the cataclysm scenario - without active investors, there's essentially no oversight for companies and no regulation of their prices by intelligent market forces. Rather, the stock will go up while it's in an index, and the only way it'll be removed from it is not gradually as it declines with increasing investor concern, but suddenly as the company goes bankrupt in a surprise to all.
What's to be Done - Bad Ideas
There are a couple of ideas that could mitigate these issues, but I think they are bad and won't work - but they might get tried.
First, companies or markets may chose to forbid passive investment in themselves somehow. This is unlikely since nobody wants less trading or more supervision.
Second, some means may emerge to counterbalance the supply and demand trends from the passives - for example to make long term bets against the index.
Indexes themselves may change how they are composed to somehow mitigate liquidity constraints. EG an index could "self re-balance" to avoid soaking up the entire stock of any given company.
What's Actually Going to Happen
So the thing to remember is that passive investment isn't some amazing thing - its successful against active managers because it's "just as wrong on average but a lot cheaper." An active investor is human - emotional, greedy, scared, biased - and he wants to get paid for his work. The indexer "wins" not by being smarter but by not thinking (and thus, allowing his emotions to bias him) at all, and paying less in the process.
For example, imagine that the active manager was information driven but cheap and free of human biases - like an algorithm that did analysis of a stock and valued in on just two factors: predicted dividend flow over the long term, and impact of passive investing flows on the price of the stock based on knowledge of the index and the overall pattern of cash flows in and out of the market. This should win over the passive guys in average - it uses 2 decent data points: one pertaining to actual income from the company and one pertaining to predictable market forces - while passive uses no data points. And the cost at the end of the day should be roughly similar.
Over time, such investors ought to draw funds away from purely passive - they ought to offer better performance at similar cost, by choosing companies based on fundamentals.
So, back to fundamentals?
At the end of the day, a company should be worth the present value of all its dividend flow. While everyone's more interested in how much they can sell the stock to someone else for, at the end of the chain somewhere someone must be getting revenue from the business, not the "greater fool" to whom they can sell their shares. As investors, we don't think about dividends much because we think about capital gains and the stock price is driven today by tons of factors not related to fundamentals - the fact that a brainless passive strategy is something we even consider talks about how crazy we've gotten with valuations and trading. The passive investment trend should smooth things out while increased technology and data transparency can allow us to actually make better investment decisions at a low cost as a matter of fact.
