Water can dramatically change the landscape, as the slow but steady process of erosion creates cliffs, caves and oxbow lakes.
A similarly remorseless transformation has been occurring in the fund management industry as active managers (those who like to select stocks) have been outcompeted by passive managers (those who track an index).
It was a sign of the times at the end of last year when the amount of assets invested in US passive funds reached $13.3tn, according to Morningstar, just pipping the $13.2tn invested in active funds. Another signal in January was the decision of Abrdn, the active manager, to shed a tenth of its staff in a cost-cutting exercise, having previously lost most of the vowels in its name.
Passive management has gained ground because it is cheap, with annual management fees often a fraction of a percentage point. And they offer a competitive return: index funds will never be top of the league tables but nor will they be bottom. But their steady rise to domination of the retail investment market prompts a question: are investors right to favour passive funds against the tried and tested active alternatives?
Falling short
Until recently, many investors preferred active managers because they promised above-average returns. The problem was that, while some active managers do beat the index in any given period, it is very hard to spot them in advance.
That is bad news for the retail investor since the average fund manager will fail to beat the index in the long run. The index represents the performance of the average investor before fees: and thus the higher fees charged by active investors drags down their average performance.
S&P publishes a regular report on the performance of mutual funds. In the 10 years to the end of June 2023, 77 per cent of actively-managed sterling-denominated UK equity funds had failed to beat the index and 95 per cent of global equity funds had done the same.
There was no equity sector in which the majority of funds had beaten the market over one, three, five or 10 years. When it came to fixed-income funds, performance was a little better over one year, but not over 10: 95 per cent of UK government bond funds had underperformed their benchmark.
In terms of US mutual funds, S&P’s data set is even longer and the trend is even more disappointing. Over 20 years, more than 90 per cent of actively-managed equity funds in every sector underperformed their benchmark. Furthermore, more than half of all active managers have fallen short of the index in every year since 2009.
But what about the funds that do outperform? Why not pick those? The problem lies in identifying them in advance. Say you had picked one of the mutual funds in the top quartile (the best 25 per cent) of European-based funds at the end of 2018. S&P found that, in five of the six equity fund categories and three out of four fixed income sectors, not a single fund manager managed to stay in the top quartile for each of the next four years. In another test, S&P looked at US mutual funds.
It calculated how many funds that were in the top 50 per cent of performers over the five years to 2017 stayed in the top half over the following five-year period. If performance was random, 50 per cent of funds could do this. But in no category did even close to half of funds manage this feat.
The great danger of chasing performance can be illustrated by ARK Innovation, once one of the hottest active exchange traded funds (ETFs) on the market. At the end of 2019, the ETF had just $1.86bn under management. In 2020, the fund’s tech-heavy focus led to a phenomenal 153 per cent return.
Money poured in from investors and by February 2021, the ETF had $27.9bn in assets. But those new investors did not enjoy stellar returns; the fund lost 23 per cent in 2021 and 67 per cent in 2022. Despite a strong recovery in 2023, anyone who bought into the fund on the back of its 2020 performance will be severely disappointed. On the latest estimate, the fund’s assets have dropped back to $8.3bn.
It is hardly surprising that there is no reliable way of picking outperforming funds in advance. If there were, why would anyone invest in any other type of fund? Small wonder that passive funds have been gaining ground.
As Warren Buffett, one of the most successful investors in history, put it: “By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
Capitalism vs Marxism
A broad view of the changes in the fund management industry is that a cheap and efficient bunch of competitors has used technology to take business away from long-established, stodgy incumbents.
It has happened in many other sectors like retailing and manufacturing. When it happened in those industries, fund managers usually cheered on such industry changes, showing little sympathy for the older companies that lost market share.
When it comes to their own industry, traditional fund managers have not been so welcoming of change, with one group even accusing passive investing of being “worse than Marxism”. This criticism is based on the idea that the stock market is all about the efficient allocation of capital.
Active managers are trying to select the companies with the best long-term growth prospects, so the argument goes, whereas passive investors are making no such judgments. The rise in passive investing will thus undermine economic growth in the long run.
Alas, this case is pretty threadbare. Indexing occurs when companies are already quoted on the stock market. This dents the capital allocation argument since quoted companies don’t spend a lot of time raising new equity; indeed, in recent years, it has been common for companies to return capital to investors via share buybacks. Those who allocate capital to young, growing companies are the banks (for debt) and venture capital funds (for equity); in neither sector does indexing have an impact.
Mergers and acquisitions are another way in which capital is reallocated from weaker firms to strong ones. Has that declined with the rise in passive investing? Not really. While 2023 turned out to be a quiet year for takeovers, the US M&A market saw record volume in 2021, when deals were worth $3.5tn, surpassing the previous records set in 2018 and 2019. Nor is there any sign that companies are getting less profitable, which would presumably be a consequence of capital being misallocated. Across the OECD, corporate profits are at the highest level, as a proportion of GDP, in the past 30 years.
A further problem with the “capital allocation” argument is that many active managers are pretty short-term. There is a reason why companies tend to get paranoid about missing their quarterly earnings numbers; if they do, their shares can fall sharply in price. That makes it harder for executives to plan for the long term. Passive investors, by contrast, will only sell if the stock drops out of the index; they are reliable long-term investors.
A related argument against passive investing is that it can lead to bubbles. Active investors will sell shares in overvalued companies and buy cheap stocks. Passive investors will simply allocate any new investor inflows into the stocks in terms of their current market capitalisation. If Microsoft is the most valuable company in the S&P 500, then Microsoft will be the largest recipient of money from an S&P 500 index-tracker. Thus, critics say, passive funds may be to blame for the current concentration of the S&P 500, with the top 10 stocks worth about a third of the index.
It is certainly possible that passive funds have played a part in the concentration process. But it is worth putting the development in context. There have been highly concentrated markets before; in the late 1990s when TMT (technology, media and telecom) stocks dominated and in the early 1970s when investors focused on a Nifty Fifty set of stocks that seemed to have secure long-term growth prospects.
In the first case, passive funds were a much smaller part of the market. In the early 1970s, they were yet to exist. Furthermore, not all index funds replicate the big indices in a way that fuels concentration. There are index funds that invest in high-yield stocks or smaller companies, for example; in neither case would such funds have big positions in tech giants like Apple or Nvidia.
Bubbles can occur, regardless of the passive sector, because active managers are quite capable of chasing fads. No portfolio manager wants to explain to their clients why they failed to back the hot stock in a particular year. Indeed, many active managers stick close to the index to ensure they do not substantially underperform it; investors pay active fees for passive performance.
Passive aggressive?
A further worry about the rise of passive investing is that some individual fund managers are becoming too dominant and thus too influential. BlackRock, the world’s largest investor, has about $10tn of assets under management; of which about two-thirds is passively managed. Vanguard, the next biggest group, has $8.7tn on its books, of which around four-fifths is passively invested.
Of the two, BlackRock has come under greater criticism because of the focus of Larry Fink, its chief executive, on environmental, social, and governance (ESG) investing. As part of the depressing tendency in American politics for all sorts of subjects to be dragged into a culture war, Republicans argue ESG investing is driven by a “woke” agenda. Vivek Ramaswamy, a former Presidential candidate who now endorses Donald Trump, has accused BlackRock of being a member of “the most powerful cartel in human history”.
Note, however, that this is a diametrically opposite claim to that made by the “worse than Marxism” group, referred to earlier. The latter group argued that passive investors were not doing enough to affect the direction of business; the anti-ESG group says they are doing too much. In any case, pursuing an ESG agenda is not restricted to BlackRock; plenty of active managers do the same. The Global Sustainable Investment Alliance, a membership organisation including both active and passive funds, estimates that $30tn is invested in sustainable assets worldwide.
So quite a few of the arguments against passive investing can be dismissed as sour grapes, or as the unfortunate side-effect tendency of toxic US politics. But there are a couple of consequences that are worth further debate. In theory, it is possible that passive funds’ dominance of the market might become so great that liquidity starts to suffer, since index funds only trade when they get new inflows or outflows.
Judging the level at which this might occur is hard; one hedge fund manager estimated that this might be when passive reached 80 per cent of the market. As yet, there does not seem to be a problem; the average monthly turnover on the New York Stock Exchange was $2.2tn in 2023; on the Nasdaq it was $2tn, according to the World Federation of Exchanges.
Another interesting question is whether the dominance of passive investing will create more profitable opportunities for active investors. Stocks tend to rise when companies join the index, because passive funds have to buy them; something smart traders have already learned to exploit. Index funds are not looking for market anomalies, such as underpriced stocks which, in theory, should create more opportunities for active investors to find them.
In aggregate, however, the maths are against active investors. If passive investors are 80 per cent of the market, and active 20 per cent, then the performance of the index will reflect the average performance of that rump 20 per cent. And, as already noted, the costs incurred by active investors will cause their average performance to lag the index. Another way of looking at the issue is that active investors must be “overweight” some stocks; in other words, have a bigger position in such shares than their weight in the index. But for them to do so, other investors must be “underweight” those same stocks and will thus underperform if the first group is right.
Cheap and cheerful
It seems highly unlikely that active investing will disappear altogether. There will always be people who think they can beat the market, and the potential to make a lot of money will be a great incentive for those who want to attempt it. There will also be plenty of clients who regard passive investing as rather dull, and would rather take the chance of backing a high-flying fund manager. And there are also lots of people with the urge to gamble, as demonstrated by the enthusiasm for spread betting, or speculative assets such as bitcoin.
But the wise private investor can ignore such distractions, and should not be too bothered by the theoretical debate about the merits of passive investing. The change in fund management has been undeniably good for the retail investor. For too long, they paid high fees for mediocre performance.
It is not just that passive funds are cheap. Their competitive threat has had a significant impact on fees elsewhere. Data collected by the Investment Research Institute, a US trade body, found that the average expense ratio for all equity mutual funds has fallen by 56 per cent since 2000.
In other words, private investors are keeping more of their own money; the City slickers are keeping less. Their philosophy may be passive, but index funds have actively made things better for private clients. Long may the tide be in their favour.
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