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Long Story Short - Passive Funds Will Likely Top 50% This Year; What Does This Mean for Financial Markets?
Active vs Passive Investing: Is there Still a Place for Stock Pickers?(Note: companies that could be impacted by the content of this article are listed at the base of the story (desktop version). This article uses third-party references to provide a bullish, bearish and balanced point of view; sources listed in the "Balanced" section)
At some point in 2019, the market share of passive funds will top 50%, marking an inflection point in the active versus passive debate. Since the end of 2006, investors have withdrawn approximately $1.2 trillion from actively managed U.S. equity mutual funds and have allocated some $1.4 trillion to U.S. equity index funds and exchange traded funds (ETFs). At the end of 2018, mutual funds and ETFs that passively track indexes held 48% of market assets. By definition, active portfolio management focuses on outperforming the market compared to a specific benchmark, while passive portfolio management aims to mimic the investment holdings of a particular index. But, as we shall see, the line between passive and active investing is not black and white.
Less Competition for Active Managers. With a 50/50 mix between passive and active investing in the equity market, there is less competition for investment ideas for active investors. Passive managers are now the largest shareholder in at least 40% of all U.S. listed companies. With this much indifferent passive investment in the marketplace, there should be even more opportunities for sharp stock pickers to find mispriced securities.
Asset Class and Market Conditions Matters. Research suggests that, depending on the asset class, active managers are more likely to outperform their benchmarks on a net of fee basis. For asset classes such as international equities and small cap equities, active managers more than earn their fees. Interestingly, according to AQR Capital Management, the empirical research shows that active stock-pickers tend to outperform during recessions as well as in times of high dispersion between stock-specific returns and especially during “differentiated declines” (i.e. when weak markets and wide dispersion coincide).
Stock Pickers Can Exploit ETF Anomalies. Recent studies indicate stock pickers may be able to exploit documented correlations among ETF constituent securities during major selloffs. According to a paper in the Financial Analyst Journal, “When high volume selloffs occur, ETF investors may be leaving as much as 200-300 bps of alpha on the table for stock pickers to capture over the following 40 days. Such events occur, on average, 30 times per year.”
Passive Market Share is Overrated. More than half of all global equities are managed internally and thus not publicly measured in the way delegated external asset managers are. A BlackRock study estimates that out of $68 trillion of global equities, only $12 trillion, or 18% are passively managed.
It’s All About Performance. During any given year, between one-half and three-quarters of active managers lag behind their benchmark indexes. According to Princeton University professor and author of ‘A Random Walk Down Wall Street’, Burton Malkiel, “A low-cost index fund outperforms two-thirds or more of active managers over time. And the one-third that outperform are never the same from one period to the next.”
Closet Indexing. When is active investing actually passive investing? The risk of outflows if active managers underperform their benchmark causes a significant number of active managers to avoid portfolios that deviate substantially from those of the market index. In many countries the share of closet indexing is the same as, if not higher, than explicit indexing.
And Fees Matter. According to Morningstar, the average active fund charges 0.78% in annual fees, versus 0.18% charged by passive funds. Over time, the difference in fees can have a significant impact on returns.
The Trend is Your Friend. According to PWL Capital, the market share of “passive funds” (categorized by Morningstar as “passively managed, long-term, which includes index funds but excludes sector, leveraged, and inverse mutual funds and ETFs) grew from 16% in 2006 to 37% in 2018, while the share held by active funds fell from 84% to 63%. In dollar terms, passive funds increased their assets under management over the measurement period by $5.1 trillion, to $6.3 trillion, while active funds saw a $4.3 trillion increase over the same period to $10.8 trillion. In terms of new money, passive funds attracted $3.8 trillion over the period compared to just $583 billion for active funds.
Big Data Continues to Grow. The majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals according to Marko Kolanovic, global head of quantitative and derivatives research at JPMorgan. Mr. Kolanovic estimates “fundamental discretionary traders” account for only about 10 percent of trading volume in stocks. Passive and quantitative investing accounts for about 60 percent, more than double the share a decade ago.
Finding the Best of Both Worlds. So, is there still room for active investors in a world being dominated by passive investors? Rather than an either/or answer, maybe the key for investors is to understand that in some instances passive investing might be a better choice and in other circumstances paying up for an active manager is the right choice.
Passive Investing Vehicles Close The Gap With Active Management, David Thomas, Morningstar, February 4, 2019
Passive vs. Active Portfolio Management: What's the Difference?, Nick Lioudis, Investopedia, April 24, 2019
Active vs. Passive: The Case for Both and a Place for Both, Aaron Hodari, Kiplingers, February 14, 2019
The Revenge of the Stock Pickers, Lynch, Page, Panariello, Tzitzouris, Giroux, Financial Analyst Journal, Volume 75 Number 2
Is That Active Fund Worth the Fees?, Schwab, November 14, 2016
The implications of passive investing for securities markets, Sushko & Turner, BIS, March 2018
The Active vs. Passive Fund Monitor, JPMorgan estimates, Raymond Kerzerho, PWL Capital, April 2019
Just 10% of trading is regular stock picking, JPMorgan estimates, Evelyn Cheng, CNBC, June 13, 2017