Passive investing has now become a phenomenon that is essential to both professional and retail players. Passive management is slowly, but surely, casting doubt over the relevance and success of active management.
Essentially, passive investing is modelled on the idea of mutual funds and ETFs – funds that track a specific market index. Market indexes can be traced back to the late 1800s to Charles Dow, founder of Dow Jones & Co., who wanted to create a means to track the overall direction of the market.
Passive funds are more than merely an accessible, digestible way of investing. Passive funds hold enormous stakes in public firms and if the three largest asset managers (BlackRock, Vanguard and State Street) were combined, they’d represent the main shareholder in over 40% of public American firms.
$600bn of US actively managed holdings have been sold since 2008 whereas flows into passive vehicles have surmounted
to $1trn which shows the divergence in growth rates of each strategy. It is estimated that passive vehicles bring in $3bn daily and 30% of assets are now allocated to passive instruments.
Poor Performance of Active Managers
The above graphic shows the inconsistency that often comes with active management investing. This inconsistency can be attributed to a number of reasons, one of which is the personalised style of active management. Active managers often favour a specific style of investment (e.g. value investing) but these styles often have a cyclical nature and what may perform and beat the benchmark one year may not necessarily be successful the following year.
Interestingly, the pitfalls of active investment do not purely lie in the personal mistakes of managers but can also be seen in the practicalities and efficiency of active management. Passive funds have the potential to benefit greatly from economies of scale and therefore can charge lower costs which accentuate their attractiveness to customers. However, active funds cannot benefit in the same way. As active funds outperform the benchmark, more capital is allocated to them and the managers will have to make more, new investments.
The problem with active managers receiving more funds and increasing their exposure to markets is that these new investments have the potential to dilute their best-performing ideas, thereby suggesting that active management actively experiences diseconomies of scale. Having the misfortune of experiencing diseconomies of scale is an extremely debilitating factor for money managers in an environment where an increasing number of people want to invest their money due to digitalisation and simple internet access to markets.
The Benefits of Passive Strategies
There are multiple technical reasons why passive investment strategies are becoming more popular than active strategies.
Firstly, the fees accumulated from passive investment are significantly smaller than active: one can expect to be charged roughly 0.20% annually for passive funds whereas fees for active management are usually around 1.35% per annum.
Secondly, passive strategies allow for tax minimisation. A key feature of passive investing is that the levels of buying and selling are kept to a minimum which therefore allows for the reduction of investment-related taxation. Thirdly, a vital component of successful trading and investment is psychological discipline and self-control. One of the benefits of passive investing is that it distances the individual from decisions about what to buy/sell so, therefore, it is easier to endure the volatility and gyrations of the market.
Furthermore, investing in a passive index of a particular market will allow the investor to diversify their equity holdings
each year as firms enter or leave the index. Allowing for diversification in equity holdings is especially useful for retail investors who do not have the skill or knowledge to analyse and value equities.
Passive-Related Trepidation
One issue with a world that focuses the majority of its investment activity on passive strategies is that capital cannot be allocated efficiently, which will, in turn, lead to market failure. One of the most important roles of financial markets is to allocate capital to firms based on their efficiency however if one is to invest via index funds then the capital to be invested is allocated to all of the firms in the benchmark, not the most efficient ones.
The problem of inefficient capital allocation is even further accentuated as active managers often stay close to the benchmark index due to fear of underperforming which depletes the number of ‘activist investors’ who often take on the role of monitoring and restructuring corporate strategy. Furthermore, investors that purchase an index fund do not have the ability to sell the stocks of a particular firm that may be exhibiting poor management practices. Overall, the power of capitalism could be eroded due to funds following a more passive route.
Index funds are also the source of competition problems in the asset management industry. Previously, the asset management
industry was extremely dynamic and competitive due to the difficulty of constantly increasing market share: it was rare to not experience a period of poor performance where capital would flow out. However, when deploying passive strategies an asset management firm will never fail to perform worse than the benchmark and, more importantly, the economies of scale experienced will allow the behemoths of the industry to decrease fees to a level that prices many other firms out of the market.
Another worry emanates from the possible losses that could be incurred from passive strategies in times of severe market
distress. Many current and popular passive funds have not yet been subjected to a period of severe market turmoil. However, due to the extreme exposure that owning all of the products in a particular market brings, the losses than at investor may face could be significantly worse. The specific design of some passive products also leaves a worryingly large amount of scope for investors
to be hurt in a market downturn; bond indices are usually weighted by volume which means that investors end up exposed to borrowers that have the most debt – who are often the ones to suffer most in a period of downturn.
Finally, the rapidly growing popularity of passive investment strategies has led to the intense growth of index providers such as MSCI, FTSE Russell and S&P. These major index providers can control an enormous amount of investment flows by simply adding or subtracting a firm/country from the index- this level of control and influence has historically never been healthy for markets and institutions.
In Conclusion
As is the case with many of the revolutionary developments of the modern age, regardless of whether you are comfortable with
them or not there is scant alternative other than to accept and embrace them. It is often the case that even the staunchest opponents are convinced of the benefits of a process when they are forcibly exposed to the thing in question. The only thing left to do is enjoy the benefits that come with innovation.
Admittedly, there is still strong demand for active managers in fixed income however as time goes on many believe that the
specifics of passive investment can be readily applied to the bond market and be as effective as they are within equity markets. Interestingly, the rapid growth in passive investment actually provides the opportunity to take almost an active approach in a
passive arena – there are currently more stock market indexes than stocks and every single day the number is increasing.
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