It’s official, exchange-traded funds (ETFs) and other passive investment vehicles have taken over from traditional (and more expensive) stock-pickers, according to Bloomberg.
In August 2019, assets in passive US index-based equity mutual funds and ETFs topped those in active stock funds for the first time. Passive investing raised $4.271trn, compared to the $4.246trn raised by stock-pickers, Morningstar notes.
The explanation for this tipping point can be found after the 2008 financial crisis, which triggered investors to flock to low-cost passive funds as they tried to manage volatility, according to Bloomberg. This trend has continued for nearly a decade – and shows no sign of slowing as we head into the 2020s. “If the shift keeps gathering momentum, the implications will be enormous for industry pros, financial markets and ordinary investors everywhere,” the publisher explains.
Valuation of funds raised by passive investing
Will we see the trend continue into 2020?
Global advisory firm Deloitte points to steady growth for investment management over the past nine years, but the mix of investments has changed dramatically. Passive funds have outperformed active funds on average, with the exception of private equity. Passive funds are also a more cost-effective way to participate in the market. According to Bloomberg, passive equity funds in the US cost an average of 10 cents per year per $100 of assets, compared with 70 cents for active funds.
This shift has taken place during a turbulent economic backdrop in which investors may well be looking at a European recession, a slowdown in China, and a confusing Brexit deal. As these trends are likely to continue into 2020, passive investments are likely to appeal this year too.
In the mutual fund and ETF category, in particular, products focusing on sustainability, market volatility and megatrends will be the focus in the near future, according to Deloitte.
In Europe, 168 new sustainable funds were launched in the first half of 2019, meaning the segment is likely to exceed the 305 new sustainable offerings introduced in 2018. Regulatory developments in the EU, such as the creation of a standard environmental, social and corporate governance (ESG) taxonomy and ESG-specific benchmarks, may drive the growth of sustainable funds even further, the firm notes.
Additionally, new megatrend funds focused on global challenges including urbanisation, healthcare, and technology disruption have also recently been launched. “These thematic approaches may draw a stronger connection with investors in 2020 than some previous classification systems, such as large cap value, which are devoid of emotional connection,” says Deloitte says.
“These thematic approaches may draw a stronger connection with investors in 2020 than some previous classification systems, such as large cap value, which are devoid of emotional connection” - Deloitte
So, with the firm’s prediction considered, it appears likely that passive investing will grow from strength to strength. However, the it also states that investment managers could cross boundaries and find new ways to work in 2020. Active investors, for example, are looking at incorporating AI algorithms and alternative data sets to augment investment decision processes, which could help them regain ground in the future.
Does this mark the end of active investing?
According to some, the recent headlines about passive investment’s prowess have been overstated. “The hype about passive taking over the investing world is just that – hype,” Barry Ritholtz writes in Investment News. Mutual funds and ETFs may be well-known among the public, he argues, but they are only a small part of the investing universe.
According to Fran Kinnery, global head of portfolio construction at Vanguard, there is about $35.6trn in publicly traded shares in the US. Passive investment’s contribution of $4.271trn, therefore, amounts to just 12% of the total equity market. Although this figure has doubled in a decade, it is not yet dominant, according to the portfolio expert.
Valuation of publicly traded shares in the US
Additionally, it is also noted that despite the fact that passive funds have made significant impact in the US, it is less prevalent internationally. “The rise of passive indexing has been the most significant investment trend of the past decade. It is worth noting, however, that the total amount of money managed passively is a tiny share of the world’s total assets,” says Ritholtz.
“Global equities are more than $82trn; fixed income is $103trn; there are trillions more invested in currencies, commodities and real estate,” he adds.
What happens if passive investing dominates in the long-term?
Some investors, including renowned hedge fund manager Michael Burry – the man who foresaw the sub-prime mortgage crisis in 2008 – believe that the incline in passive investing could trigger the next financial crash.
Burry says that those flocking to index funds in the past few years have created a large-cap “bubble in passive investing”, which unnaturally beefs up the performance of both the indexes and stocks that forms them.
The problem may be expanded as markets in Europe catch up with US counterparts. According to ETFGI statistics, ETFs in Europe now hold more than $1trn worth of assets under management. That represents a doubling in size over the past four years.
John Stepek, writing in Money Week, argues that a new crash is unlikely to happen as a result of increased interest in passive funds. “This is not a black and white issue. You can believe a number of things simultaneously. For example, the rise of passive funds, in combination with a never-ending, central-bank-underwritten bull market, may well be distorting capital flows in some subtle or not-so-subtle manner,” he explains.
“This is not a black and white issue. You can believe a number of things simultaneously. For example, the rise of passive funds, in combination with a never-ending, central-bank-underwritten bull market, may well be distorting capital flows in some subtle or not-so-subtle manner” - John Stepek
“There is also the ever-so-slightly more niche risk that certain passive funds may be creating an illusion of liquidity where there is none – in much the same way as the highly actively-managed Neil Woodford funds blew up last year. But none of these potential problems makes passive funds, in and of themselves, ‘bad’ things,” Stepek adds.
Stepek suggests that passive funds are merely another evolution in the market. He thinks that, as they’re now a fundamental part of the markets, their involvement in any new crash is inevitable. What he does not think is that they will be the cause of it.