A billionaire whose investment house makes a business of forcing changes in firms has come out strongly against the trend of what is called passive investing.

A prominent shareholder activist and US billionaire has jumped into a debate about the pros and cons of so-called passive investing, claiming this approach to managing money could end up damaging the free market.

Paul Singer, founder of Elliott Management Corp, reportedly (source: Bloomberg) said in his firm’s second-quarter letter, dated July 27: “Passive investing is in danger of devouring capitalism. What may have been a clever idea in its infancy has grown into a blob which is destructive to the growth-creating and consensus-building prospects of free market capitalism.”

(Family Wealth Report has contacted his firm to confirm the letter’s contents and seek further comments, and may update in due course.)

“In a passive investing world, small shareholders have little-to-no voice and no realistic possibility of banding together, while the biggest shareholders have no (repeat, no) skin in the game so long as the money manager does not under-perform the index by five-hundredths of a percentage point, in which case the customer calls up the money manager and starts yelling,” the letter said. There’s a real likelihood that passive investing “and its apparent stability, is unsustainable and brittle.”

His comments will, for example, chime with a number of concerns that this publication has heard from within the wealth management industry that while the use of low-cost index funds and similar structures has an obvious appeal, the approach has limits and drawbacks of the kind mentioned by Singer. Also, it has been all too easy, some say, to make the case for passive investment during an equity market bull run that has been driven by central bank money printing. The approach to investing gets tougher to sell if or when markets turn more volatile. (See a recent comment by CIBC Atlantic Trust on the case for active management here.)

Singer argues that index fund providers, unlike an individual shareholder, don’t have a reason to force company boards to improve performance. Singer’s business has tussled with a number of businesses over the years, seeking to unlock value he claims firms aren’t always willing to release. And yet there remains a clear realization in certain countries that activism can boost growth in the longer term. In Japan, for example, recent changes to corporate governance rules, which in the past stymied M&A activity and break-ups of firms, are seen as encouraging activist investors to push harder to improve return on equity.

Defenders of the passive approach argue that markets such as in equities and bonds are, broadly speaking, efficient and discount known information on firms; it is hard for more than a fraction of investors as a matter of simple mathematical logic to achieve persistent out-performance - or “Alpha” . The likelihood of beating the market isn’t sufficient enough over time to justify active managers’ fees, given the compound effect such fees are likely to have on returns. In the case of hedge funds, their traditional 2 per cent annual management fee and 20 per cent performance fees have come in for particular criticism after a period of lackluster returns.

Renowned US investor Warren Buffett, no less, blasted entities such as hedge funds for these reasons in his annual letter to shareholders earlier this year, suggesting investors would, over the past decade, have done better to hold an index-tracker fund. (See an article on Buffett’s letter here.) Ironically, Singer has clashed with Buffett in another way because of a bid to buy power distributor Oncor Electric Delivery Co.

Advocates of passive investing also argue that far too many self-described active managers hug market indices and are therefore charging excessive fees; also, innovations in the passive investment space, such as providers of "Smart Beta", where distinct drivers of returns are captured, deal with some of the objections to the passive investment approach.

The rise of passive investing has put some fund management houses under pressure, because margins are hit by fewer sales of active, higher-fee funds. Passive funds are seen as being on one end of a wealth and asset management “barbell” – cheap, commoditized products at one end, and expensive, niche-style products on the other. Those in between are squeezed out. A recent report by Boston Consulting Group, for example, (see here) has highlighted the tough environment traditional asset management has faced.