Has Indexing’s Popularity Made Active Management Easier?

Welcome to MutualFunds.com

Please help us personalize your experience and select the one that best describes you.

Your personalized experience is almost ready.

Join other Individual Investors receiving FREE personalized market updates and research. Join other Institutional Investors receiving FREE personalized market updates and research. Join other Financial Advisors receiving FREE personalized market updates and research.

Thank you!

Check your email and confirm your subscription to complete your personalized experience.

Thank you for your submission

We hope you enjoy your experience

Channels

Fixed income news, reports, video and more.

Municipal bonds news, reports, video and more.

Practice management news, reports, video and more.

Portfolio management news, reports, video and more.

Retirement news, reports, video and more.

Learn from industry thought leaders and expert market participants.

Deepen your understanding of Responsible Investing and learn how it can potentially help you build a more successful practice.

Has Indexing’s Popularity Made Active Management Easier?

Hand taking accounting notes
Since John Bogle and Vanguard introduced the first retail index fund in 1976, there has been a persistent trend (both by individual and institutional investors) away from active and towards passive investment strategies. The growing popularity of passive investment strategies, such as index funds, has led to questions about whether indexing has become too popular, leading to market inefficiencies and thus a greater opportunity for active managers.

That’s certainly what Wall Street and the financial media want and need you to believe, because active management is the winning strategy for them (although it’s the losing one for you).

Before addressing the issue, it’s important to understand that even if a majority of investors indexed (and we are nowhere near that scenario), active management remains a negative-sum game after expenses (John Bogle’s Costs Matter Hypothesis). And active investors would still be the ones setting market prices.

We’ll begin by observing that, according to Morningstar, index funds account for only about 15% of total equity holdings by market capitalization. It’s hard to argue that indexing has gotten too big when 85% of mutual fund assets are still engaged in active investment strategies. We now turn to a second important issue.

The Pool of Victims to Exploit Is Shrinking

Since generating market-beating returns is a zero-sum game even before expenses, there must be a pool of victims to exploit for active managers to generate alpha (victims who generate negative alpha). Who, exactly, are these victims? The academic literature provides the answer.

Dividing the market into two types of participants, individual and institutional, we know that many consider individual investors the “dumb” money. In other words, they’re the victims that institutional investors seek to exploit. The research shows that, on average, the stocks individual investors purchase go on to underperform and the stocks they sell go on to outperform. Since someone must be on the other side of the trade, we know it must be the institutional investors. And that’s what the evidence shows. Institutional investors do exhibit stock-picking skills. Unfortunately, after the expense of this effort, on average, the alpha from stock-picking skill turns negative. Its expense far exceeds the ability of active managers to generate alpha from picking stocks.

Understanding who these victims are is important, because the pool of victims active managers need to exploit has been rapidly shrinking. At the end of World War II, households held more than 90% of U.S. corporate equity. By 1980, U.S. corporate equity held by households had fallen to 48%. By 2008, it had dropped to about 20%.

Making matters worse, the competition seeking to exploit pricing mistakes has dramatically increased. There are now more than 7,500 mutual funds, according to the Investment Company Institute. That is 14 times more mutual funds than there were in 1979. Increased competition for a limited amount of alpha reduces the ability of any given fund to outperform.

The increased competition isn’t just coming from actively managed mutual funds. In less than ten years, the amount of capital invested in hedge funds has increased from about $1 trillion to almost $3 trillion. And with institutional investors now doing as much as 90% of daily trading, who exactly are the victims these sophisticated investors are going to exploit in their quest for alpha?

In the zero-sum game (negative sum after costs) that institutional investors are playing, the other side of the trade is highly likely to be another institutional investor. Only one of the two, however, can be on the right side of a transaction.

Is the Trend to Indexing Making the Market Less Efficient?

Efficient markets are generally characterized by low bid-offer spreads. Thus, if the market was becoming less efficient, we should see spreads widening. Yet, that’s exactly the opposite of what we are seeing. Spreads have been trending down. Vanguard found that the average spread among stocks in the S&P 500 Index declined from about seven basis points (bps) in 2009 to just under two bps as of March 31, 2014. We know from the annual S&P Indices Versus Passive (SPIVA) Scorecards that as the dollars allocated to passive strategies have increased, the relative performance of active managers hasn’t improved.

Is the Market Becoming Less Informationally Efficient?

Another often-heard argument is that the trend toward passive investing will make the market less informationally efficient. It seems hard to make that case given the incredible advances we have seen in technology and how important a role it plays in disseminating information (and doing so in such a rapid fashion).

As Vanguard’s Chris Philips noted, “Arguably more people than ever have more access than ever to information and technology. This suggests that market efficiency should be better now than ever before regardless of how much the market is using index strategies.”

As evidence that the markets aren’t becoming less efficient, just consider the returns to hedge fund investors. The performance of hedge funds for the last ten calendar years has been so poor that, in returning just 0.7% per year, these “masters of the universe” have managed to underperform every major asset class, including virtually riskless one-year Treasuries.

Return of Major Asset Classes
The bottom line is that there doesn’t seem to be any evidence that indexing has gotten too big. Clearly, there are some who will take this as bad news. However, there’s very good news for investors who have figured out that passive investing is the winning strategy.

The Good News

For individual investors who recognize that the quest for alpha is a loser’s game, the trends are all favorable. These investors benefit from the intense competition among providers of passively managed or structured funds. And competition from the many providers of ETFs, with their lower costs, has been driving expense ratios persistently lower. There are now many index products with fees in the single digits.

This trend toward lower expenses is making passive investing even more of a winner’s game. That in turn is contributing to a vicious circle for active investors. Lower costs are helping drive more investors to become passive, further shrinking the pool of victims that can be exploited and raising the hurdles for the generation of alpha. Since investors abandoning active management aren’t likely to be the ones who have been able to generate alpha, the remaining competition is only likely to get tougher and tougher over time.

The bottom line is that there’s nothing that would lead me to believe the trend toward indexing – and passive investing in general – is going to slow down. The trend away from active investing, on the other hand, is as inexorable as the tides.

Image courtesy of adamr at FreeDigitalPhotos.net

Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.


Read Next

Hand taking accounting notes

Has Indexing’s Popularity Made Active Management Easier?

Since John Bogle and Vanguard introduced the first retail index fund in 1976, there has been a persistent trend (both by individual and institutional investors) away from active and towards passive investment strategies. The growing popularity of passive investment strategies, such as index funds, has led to questions about whether indexing has become too popular, leading to market inefficiencies and thus a greater opportunity for active managers.

That’s certainly what Wall Street and the financial media want and need you to believe, because active management is the winning strategy for them (although it’s the losing one for you).

Before addressing the issue, it’s important to understand that even if a majority of investors indexed (and we are nowhere near that scenario), active management remains a negative-sum game after expenses (John Bogle’s Costs Matter Hypothesis). And active investors would still be the ones setting market prices.

We’ll begin by observing that, according to Morningstar, index funds account for only about 15% of total equity holdings by market capitalization. It’s hard to argue that indexing has gotten too big when 85% of mutual fund assets are still engaged in active investment strategies. We now turn to a second important issue.

The Pool of Victims to Exploit Is Shrinking

Since generating market-beating returns is a zero-sum game even before expenses, there must be a pool of victims to exploit for active managers to generate alpha (victims who generate negative alpha). Who, exactly, are these victims? The academic literature provides the answer.

Dividing the market into two types of participants, individual and institutional, we know that many consider individual investors the “dumb” money. In other words, they’re the victims that institutional investors seek to exploit. The research shows that, on average, the stocks individual investors purchase go on to underperform and the stocks they sell go on to outperform. Since someone must be on the other side of the trade, we know it must be the institutional investors. And that’s what the evidence shows. Institutional investors do exhibit stock-picking skills. Unfortunately, after the expense of this effort, on average, the alpha from stock-picking skill turns negative. Its expense far exceeds the ability of active managers to generate alpha from picking stocks.

Understanding who these victims are is important, because the pool of victims active managers need to exploit has been rapidly shrinking. At the end of World War II, households held more than 90% of U.S. corporate equity. By 1980, U.S. corporate equity held by households had fallen to 48%. By 2008, it had dropped to about 20%.

Making matters worse, the competition seeking to exploit pricing mistakes has dramatically increased. There are now more than 7,500 mutual funds, according to the Investment Company Institute. That is 14 times more mutual funds than there were in 1979. Increased competition for a limited amount of alpha reduces the ability of any given fund to outperform.

The increased competition isn’t just coming from actively managed mutual funds. In less than ten years, the amount of capital invested in hedge funds has increased from about $1 trillion to almost $3 trillion. And with institutional investors now doing as much as 90% of daily trading, who exactly are the victims these sophisticated investors are going to exploit in their quest for alpha?

In the zero-sum game (negative sum after costs) that institutional investors are playing, the other side of the trade is highly likely to be another institutional investor. Only one of the two, however, can be on the right side of a transaction.

Is the Trend to Indexing Making the Market Less Efficient?

Efficient markets are generally characterized by low bid-offer spreads. Thus, if the market was becoming less efficient, we should see spreads widening. Yet, that’s exactly the opposite of what we are seeing. Spreads have been trending down. Vanguard found that the average spread among stocks in the S&P 500 Index declined from about seven basis points (bps) in 2009 to just under two bps as of March 31, 2014. We know from the annual S&P Indices Versus Passive (SPIVA) Scorecards that as the dollars allocated to passive strategies have increased, the relative performance of active managers hasn’t improved.

Is the Market Becoming Less Informationally Efficient?

Another often-heard argument is that the trend toward passive investing will make the market less informationally efficient. It seems hard to make that case given the incredible advances we have seen in technology and how important a role it plays in disseminating information (and doing so in such a rapid fashion).

As Vanguard’s Chris Philips noted, “Arguably more people than ever have more access than ever to information and technology. This suggests that market efficiency should be better now than ever before regardless of how much the market is using index strategies.”

As evidence that the markets aren’t becoming less efficient, just consider the returns to hedge fund investors. The performance of hedge funds for the last ten calendar years has been so poor that, in returning just 0.7% per year, these “masters of the universe” have managed to underperform every major asset class, including virtually riskless one-year Treasuries.

Return of Major Asset Classes
The bottom line is that there doesn’t seem to be any evidence that indexing has gotten too big. Clearly, there are some who will take this as bad news. However, there’s very good news for investors who have figured out that passive investing is the winning strategy.

The Good News

For individual investors who recognize that the quest for alpha is a loser’s game, the trends are all favorable. These investors benefit from the intense competition among providers of passively managed or structured funds. And competition from the many providers of ETFs, with their lower costs, has been driving expense ratios persistently lower. There are now many index products with fees in the single digits.

This trend toward lower expenses is making passive investing even more of a winner’s game. That in turn is contributing to a vicious circle for active investors. Lower costs are helping drive more investors to become passive, further shrinking the pool of victims that can be exploited and raising the hurdles for the generation of alpha. Since investors abandoning active management aren’t likely to be the ones who have been able to generate alpha, the remaining competition is only likely to get tougher and tougher over time.

The bottom line is that there’s nothing that would lead me to believe the trend toward indexing – and passive investing in general – is going to slow down. The trend away from active investing, on the other hand, is as inexorable as the tides.

Image courtesy of adamr at FreeDigitalPhotos.net

Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.


Read Next