The Swinging Pendulum of Passive Investing
Despite a growing selection of funds investors have centralized around a passive, low-cost strategy. Major names in the financial world have long touted the benefits of a passive approach. Vanguard founder John Bogle has become the face of the movement when he launched the first S&P 500 index fund available to the public in 1975.
The argument for eschewing actively managed funds is based on their well-documented underperformance relative to the broader market. The annual Morningstar active/passive barometer reinforces this truth with a review of the numbers. Their 2015 conclusion that “Actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons,”[1] is in keeping with growing investor sentiment that “If you can’t beat them, join them.”
In a 12-month period through the end of November investors collectively pulled $358.8 billion from actively managed funds based in the U.S. Simultaneously investors put $479.8 billion into passive funds. Choice, it seems, has become something of a burden and the choices keep growing. In 1997 there were 6,778 mutual funds available in the U.S. Today investors can choose from over 9,000.[2] Technology has enabled a more robust offering, but in a frenetic work environment, people have less time to tease apart the nuanced differences.
For a period niche products like livestock ETFs and other alternative investments carried a cache. However, the disciplined investor of today seeks a reasonable rate of return and therefore has resorted to the terra firma of a passive approach. Some big name players took far too long to respond to the fact that “A generation of 18- to 34-year-olds that is larger in size than the baby boomers is increasingly opting for lower-cost passive funds.”[3] Fidelity’s sluggish answer to this movement is a collection of six new ETFs launched in 2016.
The relatively strong performance of passive funds is only part of the appeal for investors. People have become savvy on costs. Fees and expense ratios have become part of the investor’s vocabulary. Passive strategies offer inexpensive exposure to all market sectors. Investors are increasingly wary of fees eroding their gains as some analysts point to muted returns and inflationary pressure in the coming years. Studies reflect investor vigilance when it comes to costs; “Over the past decade, 95% of all flows have gone into funds in the lowest-cost quintile. Passive funds have benefited disproportionately.”[4] The people have spoken.
Actively managed funds have dropped the average asset-weighted fee by 4.8% in a bid to win back investors. Actively managed bond funds shed 6.0%. Despite these pleas the trend to passive funds continues because superior performance and lower costs can only portend great things to come.
Or can they?
The mounting concentration of assets within these passive funds has brought criticism to the fore. Some managers posit that shareholder-voting power has concentrated around just a few big name managers. Apple’s “top three institutional investors are prominent index fund managers Vanguard, State Street, and BlackRock. Combined, these three institutional owners control 12% of its shares and, naturally, 12% of its proxy votes. That's a lot of power to put in so few hands,”[5] warns one author. As more investors crowd this space equity purchases reach an enormous scale. Such inflows effectively increase the correlation among stock performance. The result: Diversification fails to defray risk.
Additionally, markets will become less efficient. Passive funds are tasked with matching an underlying index. Any decision to buy or sell shares is driven only by the need to maintain symmetry with the index. Therefore, large purchases from the likes of Vanguard and State Street have nothing to do with the fundamentals of the stocks. This phenomenon will ultimately create less efficient markets.
In a less efficient market share prices are slow to respond to factors, which may change the value of a stock. This is problematic because massive index funds will not respond to cogent market information. When you invest in a passive fund, you're committing to a practice of anchoring and holding firm no matter which way the wind blows.
However, sometimes we need to adjust the sails.
If a stock that is part of an index experiences a sharp price increase its market capitalization grows. That is, the share price times the total number of shares outstanding becomes a larger number. In some cases, an increased share price is the result of sound business practices, a competitive advantage or a strong product offering. However, sometimes, markets move with the same irrationality of those trading them. In such cases, an index fund would need to join the buying frenzy just to maintain the proper market capitalization proportions. Buying for this reason is less desirable than buying or selling based on the company’s fundamentals.
Throughout history, investors have seen evidence of these inefficiencies. In the late nineteen-nineties, the “dot com” bubble meant that any startup in the online sphere could enjoy massive share price run-ups regardless of fundamentals. Eventually, the bottom fell out. Following this came the credit bubble. Since that time we’ve seen commodities soar for a period without regard for their fundamental values. Markets are inefficient. The only quest is how inefficient are they?
In time, active managers will be able to capitalize on these inefficiencies brought on by monolithic, immovable index funds. We're not at this point yet. However, the exodus to indexing continues to grow unabated. In 2000 index funds held 9.5% of all stock fund assets. Today it’s nearly double that figure at 18.4%.[6]
The Eiffel Tower would be a beautiful place if it weren’t for all the people. Perhaps this is also true of index funds. Diversification, consistency, and low costs have always formed the bedrock of a sound investment strategy. However, in the future share prices may be influenced less by their performance and more by the baseless whims of the marketplace.
Investors have long had a critical eye on active funds. Before long it will be time to turn that gaze to the underpinnings of a passive approach. While we maintain our position that passive funds will outperform their active counterparts, rest assured we are keeping an eye on the markets so that if the pendulum ever swings too far we will be ready to make the appropriate adjustments.
[2] https://www.statista.com/statistics/255590/number-of-mutual-fund-companies-in-the-united-states/
[3] http://www.wsj.com/articles/fidelity-embraces-what-it-once-avoided-the-etf-1483444801
[4] https://news.morningstar.com/pdfs/2015_fee_study.pdf
[5] http://money.cnn.com/2015/03/31/investing/investing-index-funds-warning/
[6] http://money.cnn.com/2015/03/31/investing/investing-index-funds-warning/