2. mutual fund industry seems to have realized that they face an existential threat not just to their growth but to their very existence, and many of them are responding by cutting fees and offering passive investment choices.
3. In 2016, passive investing accounted for approximately 40% of all institutional money in the equity market, more than doubling its share since 2005.
SHIFT TO PASSIVE INVESTING
1. Active money managers are starting to recognize that they collectively cannot beat the index and that their costs (transactions and management fees) will have to come out of the index returns. Not surprisingly, therefore, active investors will collectively generate less than the index during every period and more than half of them will usually underperform the index. Here is a chart onthe median returns for all actively managed funds, relative to passive index funds for various time periods ending in 2015
2. The median of active equity fund manager underperformed the index by about 1.21% a year between 2006 and 2015 and by far larger amounts over one-year (-2.92%), three year (-2.78%) and five year (-2.90%).
3. Below is a table looking at the excess returns and the percent of active investors who fail to beat the index, broken down by style sub-group. There is not a single sub-group that has been able to beat the index for that group but also that the magnitude of under performance is staggering.
4. The following table looks at the percent of active managers who fail to beat indices in their markets. There are results in the one-year returns in Europe and Japan and in the emerging markets, but there is not a single geography where active money managers have beaten the index over the last five years.
ISSUES IN PASSIVE INVESTING
1. Corporate Governance - As ETFs and index funds increasing dominate the investment landscape, the question of who will bear the burden of corporate governance at companies has risen to the surface. After all, passive investors have no incentive to challenge incumbent management at individual companies nor the capacity to do so, given their vast number of holdings.
2. Information Efficiency - To the extent that active investors collect and process information, trying to find market mistakes, they play a role in keeping prices informative. If everyone believes that markets are efficient and invests accordingly (in index funds), markets would cease to be efficient because no one would be collecting information. If passive investing does grow to the point where prices are not informationally efficient, the payoff to active investing will rise to attract more of it.
3. Product Markets - There are some who argue that the growth of passive investing is reducing product market competition, increasing prices for customers, and they give two reasons. The first is that passive investors steer their money to the largest market cap companies and as a consequence, these companies can only get bigger. The second is that when two or more large companies in a sector are owned mostly by the same passive investors etc. Blackrock and Vanguard), it is suggested that they are more likely to collude to maximize the collective profits to the owners. As evidence, they point to studies of the banking and airline businesses, which seem to find a correlation between passive investing and higher prices for consumers. Having a lot of passive investors does not seem to provide protection against the rapid meltdown of value that are still sometimes observe at large market cap companies.
WHAT TO EXPECT
1. The Active Investing Business Will Shrink - The fees charged for active money management will continue to decline, as they try to hold on to their remaining customers, generally older and more set in their ways. Notwithstanding these fee cuts, active money managers will continue to lose market share to ETFs and index funds as it becomes easier and easier to trade these options. The business will collectively be less profitable and hire fewer people as analysts, portfolio managers and support staff. If the last few decades are any indication, there will be periods where active money management will look like it is mounting a comeback but those will be intermittent.
2. More Disruption is Coming - Businesses that are most ripe for disruption are ones where the business is big (in terms of dollars spent), the value added is small relative to the costs of running the business and where everyone involved (businesses and customers) is unhappy with the status quo. That description fits the active money management and the next wave of disruption is coming from fintech companies that see opportunity in almost every facet of active money management, from financial advisory services to trading to portfolio management.
PASSIVE INVESTING FUNDS
1. According to Morningstar, the largest and best-selling fund available to UK retail investors is the iShares S&P 500, which has gathered nearly £60bn of cash, closely followed by Vanguard’s S&P 500 tracker, with £14bn. Net of fees, the funds returned just over 42 per cent over a one-year period and around 20 per cent over a three-year period — just under the returns of the S&P 500 index in both cases.
2. Vanguard is expected to launch its own online supermarket early this year, giving investors a chance to eliminate broker fees and gain even cheaper access to tracker funds.
3. Fund supermarket Hargreaves Lansdown, which holds nearly £60bn of UK retail investors’ assets, says one in 10 investors hold at least one passive fund in their portfolio — up from 6 per cent in 2011.
4. Among the most popular fund picks for DIY investors is US asset manager BlackRock’s Consensus 85 — a fund of ten other passive funds holding a range of US, UK and Japanese equity trackers, along with passive bond funds.
5. Other popular passive picks are FTSE trackers, which follow the blue-chip FTSE 100, mid- to small-cap 250 and the All Share, run by HSBC and Legal & General Investments.
6. Robo-advice platforms — which recommend portfolios of cheap ETFs to investors based on their risk appetite
THOUGHTS
1. The question is no longer whether passive investing is growing, but how quickly, and at what expense to active investing. The answer will have profound consequences not only for our investment choices going forward, but also for the many employed, from portfolio managers to sales people to financial advisors, in the active investing business.
(Source: equities,FinancialTimes)
