This Fourth of July, Americans mark the 250th anniversary of the Declaration of Independence. The experiment it launched rests on a fundamental proposition that’s still radical today. Liberty – the freedom of individuals to choose their own destiny – is a prerequisite for a durable political and economic system.
Investment choice is not an abstraction, nor is it guaranteed. The freedom to allocate capital has fueled every innovation behind the American pursuit of happiness. Railroads, electrification, computers, space travel, the internet, medical technology and now the AI tools transforming our entire economy. Each successive wave of innovation was funded by individual investors willing to make a bet on an unproven future. Increasingly, however, investor choice is coming under pressure.
A wave of mega-IPOs is reaching the public markets, and the rules that decide which enter the major indexes (and how quickly) are being written by committees, not by investment professionals. Some benchmarks now fast-track huge new listings within weeks of their debut. When that happens, every fund built to track the index must buy in, at whatever weight and price the index assigns. No one asks whether the company is worth it from a valuation or price perspective. They don’t have to, and the concentration risk is silently absorbed by savers.
Another reason passive funds aren’t necessarily safer is that a passive fund in a declining market participates fully in that decline. The fund cannot decide that a sector is overvalued or that a holding has deteriorated. “Passive” then becomes a stubborn attitude toward risk, not just a bias toward inexpensive stock selection.
Cheap, in other words, is not synonymous with safe. Again, our focus should be on the outcomes required by the individual investor. For a 25-year-old, four decades from retirement, safety means outpacing inflation across the full span of their working life. For a 70-year-old retiree, it means a protective, low risk portfolio designed to survive the market correction she cannot afford to wait out. A poorly timed market decline late in life can permanently impair a portfolio and passive funds have no mandate to adjust to that reality.
These are real scenarios. Over the long run, the S&P 500 has returned on average roughly 10% a year, but that average conceals specific time periods that can make or break a saver’s retirement. From the end of 1999 through 2009, the index lost money. An index investor who retired in 2000 trusting the market to carry them through their golden years, absorbed nearly ten years of negative growth instead.
Active management is the cornerstone the market relies upon. When managers apply their judgment to value a company through buying and selling, they help the market set the price. This is the human powered, deeply analytic work economists call price discovery. Price discovery shapes the demand that allows new companies to go public. In a crisis, when programmatic sellers are all rushing for the same exit, it is the active manager that brings stability to volatile markets. If this active layer gets diluted or stripped away, the foundation for passive investing disappears with it.
None of this is an argument against index funds. Passive investing has been a democratizing force for good that has reduced friction for millions of new investors. Rather, it’s a case for ensuring that individuals – not government – retain a central role in determining what “safe” means for their own investments. Two investors, one 25 and one 70, do not have the same retirement objectives. Policymakers must let active and passive strategies compete on a level field and judge them by the outcomes they deliver over the long-term.
Investor choice is the purest economic expression of individual liberty. The founders made the decision that free people, exercising their own free will, should be able to shape their own economic futures. U.S. capital markets lead the world in providing investment options to retail investors. As we begin our country’s 251st year, preserving investor choice and focusing on outcomes rather than fees alone will help determine whether the next 250 years will be as prosperous as the first for all Americans.
