As we turn the page on this past decade, it’s important that we take some time to think about a few broader, more structural, issues that will shape financial markets during the upcoming decade. There are key mechanical changes taking place within securities markets at this moment. Chief among them is the shift from active to passive investment management.
This year marked an important milestone for passive index investing. Morningstar’s August 2019 monthly Fund Flows Report showed that passive U.S. equity assets passed active U.S. equity assets for the very first time. These numbers do not include assets managed outside of the ETF or Mutual Fund structure, but is still a significant development.
In the coming months I will do my best to shed some light on a few of the implications for markets as the popularity of passive investing continues to grow. How will this shift affect price information for individual securities and how might it affect overall market stability? Are there pitfalls that investors need to be wary of? These are the primary questions I will attempt to address.
What exactly is passive portfolio management (passive investing) and what are the theoretical foundations for its adoption? Passive investing is a strategy that seeks to reproduce returns of a price index, such as the S&P 500. Normally, a passive strategy will hold each security in the index in proportion to their weighting in the index. In contrast, actively managed strategies pursue higher returns than their chosen benchmark by purposefully investing in certain securities and/or sectors of the market over others. Active investors might also trade on macroeconomic views in anticipation of market turning points.
The arguments for adopting a passive investment strategy stem from the Efficient Market Hypothesis (EMH). EMH, in its strongest form, claims that security prices quickly absorb all relevant and available information so that predicting future returns is not possible. Therefore, very little room exists for active managers to achieve returns above the market. As a result, paying management fees above what is necessary to attain a diversified portfolio is futile.
The rise of passive index investing is synonymous with the behemoth investment company Vanguard. John “Jack” Bogle, the founder of Vanguard Group, is credited with creating the first investable index fund for the public in 1975. Bogle’s concept was to buy an index rather than attempt to beat the index and that over the long run, investors would realize higher returns due to lower costs versus an actively managed fund.
On November 29, 2018, The Wall Street Journal published an article adapted from Bogle’s book, Stay the Course: The Story of Vanguard and the Index Revolution. In it he writes, “Most observers expect that the share of corporate ownership by index funds will continue to grow over the next decade. It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the “Big Three” might own 30% or more of the U.S. stock market—effective control. I do not believe that such concentration would serve the national interest.” The “Big Three” he was referring to are Vanguard, Blackrock and State Street. Together these three firms control more than $15 trillion worth of assets.
In a paper titled The Shift from Active to Passive Investing: Potential Risks to Financial Stability? published by the Federal Reserve Bank of Boston in 2018, the authors point out that investment funds face some economies of scale, because greater assets under management (AUM) allows fixed costs to be spread over a larger asset base. Also, because passive funds offer only minimal differentiation of portfolios and manager talent, investors may be more inclined to invest in the lowest-cost funds which inevitably will be operated by large asset managers best positioned to take advantage of those economies of scale. The authors point out that passive funds managed by Vanguard grew more than 20 times between 1999 and 2018.
Certainly, the issue of greater industry concentration and the implications concerning proper corporate governance is extremely important; however, I believe the potential consequences concerning price discovery as well as likely effects on the overall stability of markets are even more critical.
The difficulty with this subject lies in the fact that there is very little historical data for researchers to analyze and back-test. The road ahead has yet to be traveled.
As compared to an active portfolio manager, the passive index manager gives no thought to an individual securities price, earnings growth potential, GDP forecasts, valuation ratios, etc. They are only concerned with one question: Did clients give me cash to invest or are they requesting cash to withdraw? And in which case, they must either buy or sell the entire basket of stocks or bonds in the index. This is a very different decision-making process compared with an active manager.
As the share of passive investing continues to grow, the credibility of information embedded in prices may come into question. This could lead to misallocation of capital and greater co‑movement of prices among securities making up an index. In fact, in 2017 during an interview with Yahoo! Finance, Jack Bogle himself made the following statement, “If everybody indexed, the word you could use is chaos, catastrophe. There would be no trading, there would be no way to convert a stream of income. The markets would fail.”
Why did the father of passive investing feel it necessary to issue this warning? It’s well document he loathed the offspring of the index mutual fund, the Exchange-Traded-Fund (ETF).
The main difference between an ETF and an index mutual fund is that an ETF trades throughout the day just as a stock does, as opposed to a mutual fund that reprices fund shares at the end of each day based on the value of each underlying security and its weighting in the fund plus any cash held. Investors may redeem shares for cash or purchase additional shares directly with the fund sponsor at the end of each day. Bogle believed the trading of index ETFs would breed disaster.
Bogle’s entire philosophy of low-cost index investing relies on the notion of buy and hold over the very long term. The intraday trading feature of the ETF has drawn players with much shorter time horizons into the index investing fold. ETFs have also become very popular vehicles for investors who bet against the market by short selling, with more than 20% of overall short interest coming from ETFs.
We will take a more in-depth look at the issues laid out in future articles. There is no doubt that index investing has allowed investors greater access to markets at lower costs. I myself, a vocal and proud believer and practitioner of active investment management, use index ETFs to gain exposure to certain asset classes. There is little doubt there is great benefit to this emerging trend. As prudent investors, however, we must consider carefully all the intended and unintended risks that may accompany this new phenomenon.