Why the passive index fund revolution is accelerating

Sometimes change can be so immense and disruptive that it is hard to tell catastrophe from opportunity.

Over the last three decades, passive investing styles have been slowly overtaking their active predecessors. The close of 2019 marked an end of an era when assets in US index-based equity mutual funds and exchange-traded funds (ETFs) topped those actively managed for the first time, data from Morningstar has shown.

That rise in popularity became a major concern for investors more recently, as many considered whether a herd mentality would exacerbate a market downturn.

“The behavioural biases of investors are one of the most serious risks arising from ETFs, as too much capital is concentrated into too few places,” Lance Roberts, founder of RIA Advisors, wrote in Seeking Alpha.

Those fears rang true when the world’s biggest stock fund — the SPDR S&P 500 ETF — saw some of the largest outflows in its history at the end of February. Data compiled by Bloomberg indicated that $13bn was wiped out in just three days.

“The behavioural biases of investors are one of the most serious risks arising from ETFs, as too much capital is concentrated into too few places” - Lance Roberts, founder of RIA Advisors

 

The argument is that while the risk concentration benefits of passive investing appear self-reinforcing in a bull market, in a bear market the opposite is true as passive indexers turn into panic sellers.

“While the sell-off [in late February] was large, it was the uniformity of the price moves which revealed the fallacy of passive investing, as investors headed for the exits all at the same time,” Roberts said.

 

Active exodus

After clocking record outflows in February, the SPDR S&P 500 ETF surprisingly had a bout of record inflows the following month.

Tony Thomas, senior analyst at Morningstar, notes that passive funds took in a record $41bn in March, while actives lost $31b.

The sudden uptick in inflows is not a one-off, but part of a long-term trend. “The March outflows [from active funds] were actually roughly equivalent to the outflows that they had in January, even before the sell-off began. And they’ve been in outflows for about 90% of the months of the last 10 years,” Thomas explained.

  

Furthermore, Bank of America’s April Global Fund Manager survey highlighted that the lack of economic certainty has accelerated the trend of favouring passive instruments as investors become more price-sensitive, the Financial Times reported. 

The massive divergence between passive and active funds is part of a long-standing market feud over whether to favour the high liquidity that comes with index funds or steady outsized gains. Despite active tending to outperform in difficult times, the recent massive inflows into passive funds at a time when volatility is at record levels is extraordinary.

The decision on which approach to favour ultimately comes down to whichever has a higher chance of beating the index. Historically, actively managed funds have proven their worth in turbulent environments and coupled with an evidence-based high conviction make for a solid investment approach.