Passive investing does not exist. It is a comforting fairy tale we tell ourselves, while we all press the same buttons en masse.
Exchange traded funds, smart beta, factor strategies: they sell simplicity, calm, and scientific rigor. “You simply follow the market.” “You believe in factors.” “You do nothing.” But anyone who thinks nothing is happening here is not looking closely enough. Because precisely by doing nothing, a great deal is happening today.
Factor investing is the latest chapter in an old story. Investors discovered that returns are not random, but are related to characteristics such as size (small, mid, or large caps), fundamental value (value), momentum, or volatility. This led to investment strategies based on those specific characteristics, or factors.
That first insight was revolutionary. What follows never is. Once an insight is packaged into products that everyone can buy, it changes from knowledge into behavior. And behavior has consequences.
What happens? When investors trade the same factors en masse through composite products such as ETFs, they no longer trade individual stocks, but bundles. They buy “value” or “momentum” as if it were a single stock. This shifts the way information is incorporated into prices. Less company specific, more systematic. Less nuance, more synchronization.
The effect is simple. Prices move more in tandem. Liquidity appears to increase, but it is fragile. And anyone who thinks the market becomes more efficient is mistaken: it mainly becomes different.
No neutral choice
The central point is uncomfortable: factor products improve the tradability of factors, but do so at the expense of the informational value of individual prices. In other words, the market becomes better at pricing “the factor,” but worse at pricing the company. That is not a detail. It is a fundamental shift in how markets function.
Yet the narrative that factor investing is passive stubbornly persists. That is understandable. Passive sounds responsible. It suggests humility toward the market. But factor investing is not a neutral choice. It is an explicit position. You are not saying, “I do not know.” You are saying, “These are the risks that matter.”
And that has consequences. When many investors follow the same factors, they amplify one another’s trades. That increases volatility and can actually cause liquidity to evaporate at the moments it is needed most. The paradox is painful: products that promise liquidity can collectively undermine it.
So the real question is not whether factor investing works. The question is whether we understand what it does when everyone uses it at the same time. Markets are not laboratories. They respond to our models. And once models reach scale, they change the reality they seek to describe.
That makes this debate urgent. Not only for investors, but also for regulators and academics. Because if prices contain less and less company specific information, they lose their social function. Capital then flows not to the best companies, but to the most popular characteristics.
Perhaps that is the greatest irony. Factor investing began as a refinement of market thinking. It may end as a simplification of it. Passive investing does not exist. It exists only as long as you do not look at what is happening under the hood. And that is precisely where the market is being made today.
Gertjan Verdickt is assistant professor of finance at the University of Auckland and a columnist at Investment Officer.