What Does the Rise of Passive Fund Use Mean for the Market?

Forty years on from the launch of the first every passive fund. Morningstar looks at what the rise in popularity of trackers and ETFs mean for the investment market

Ben Johnson 25 October, 2016 | 16:14
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As index funds continue to rise in popularity, there have been increasing questions about what this means for the market as a whole. Our Director of Global ETF Research, Ben Johnson, for some thoughts on the topic. We're 40 years in from the launch of that first retail index product, no signs of a slowing down in terms of gathering assets. But there are some people now who are questioning what it means for the market as a whole. We're here at the 40th anniversary of the first retail index mutual fund which was launched by Vanguard in the mid-1970s and was not all that well received by many of Vanguard's competitors. It was labeled as Bogle's folly.

And oddly enough almost as if to commemorate this anniversary there was recently issued by a team at Sanford Bernstein a sell-side equity research note that questioned whether or not passive investing might actually be worse than Marxism. So, there are these big picture questions and some pretty racy headlines out there asking whether or not we've gone a bridge or two too far in terms of investors' adoption of passive strategies of all sorts. So what are some of these arguments against it?

Many of the arguments tend to in one way or another claim that as index funds as a whole command a larger share of invested or managed fund assets that it will in some way either make markets less efficient or throw a wrench into the machine that allocates capital to various projects, various firms, be they entrenched, be they startups, within the broader economy.

So there are important questions I think out there with respect to market efficiency and price discovery and index funds and index funds' adoption effect on that mechanism as well as sort of this social and economic good that is capital allocation in how we steer money towards projects that will ultimately create value, either monetary or otherwise, for humanity at large or grow our economy.

When you look at the evidence, do you think that that's a reasonable theory or do you think that this is just kind of overblown hand-wringing? I think it's a bit overblown frankly and I think some of the claims are somewhat self-serving. If you look at active management at large, it's been on the retreat, it's been put on its heels. It's really witnessed a lot of pain, a lot of outflows since the worst of the financial crisis. And what's that's doing in terms of this function and the growth of indexing I would argue if anything might be making markets more efficient by weeding out the weaker hands.

So, everyone who opts out of active or allocating money to actively-managed strategy says, you know what, I'm not a stock picker, I'm not a bond picker. I don't have the time, the resources nor the inclination to do so, so I will step away from this table. And arguably, the players who are left at the table are the most skilled, the most intelligent, the most competitive players, the most highly competitive field that's ever existed. So we would argue that if anything markets might becoming more efficient as a result. Capital allocation decisions and that function might ultimately improve as a result.

Can indexing get too big? Is there a point where there's just no one left at the table? Johnson: So that's a very important question. So, if you look at where we stand today, index funds and exchange-traded funds that are passively-managed, so they are tied to an index, account for roughly a third of the overall U.S. funds industry. In some corners of the industry, that's even larger share still. So if you look at within U.S. equities, for example, you'll see that some 40% of overall fund assets are invested in index mutual funds or exchange-traded funds.

Now there's still quite some way to go to get to what is a purely theoretical nonsensical 100%. Index funds will never command 100% of any market. Active management will never die. It will never go away. There will always be an ebb and flow. There will always be trends. Active management will always serve a very important function, a critical function.

Expectation setting with index funds is another aspect to be concerned. A concern that I've had, as sensible as using a cap-weighted index fund as maybe your whole U.S. market exposure, or maybe for the whole of your portfolios is, that there are times when cap-weighted indexing, like right now, looks really good from a performance standpoint. That may not always be the case. So investors shouldn't derive too much comfort from the fact that near-term results have been spectacular. They may not always be so.

Absolutely the case. And I think there's the risk now, that we're almost in this echo chamber of sorts where all the cool kids are doing it. And everyone's jumping on the bandwagon, and directionally, flows are all headed in the same direction, which is toward index funds and low-cost index funds, which I would argue from a very long-term point of view is a good thing. But between here and the very long term, there are going to be cycles. And the cycle that we're in currently has been very favorable for index funds and investors in index funds. But that's not to say that there aren't going to be periods of time in the future, and there inevitably will be, where you're going to feel like the odd person out at a cocktail party, holding on to your S&P 500 Index Fund or your Barcap Agg Index Fund, because inevitably, there's going to be those cycles of performance over a very long period of time. You can hang your hat on those structural advantages I mentioned earlier, but there are going to, again be those bouts of relative underperformance versus active managers or even other index strategies. To sum up, absolute losses may be there, as well as underperformance relative to other strategies. 

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Ben Johnson  Ben Johnson, CFA is the Director of Passive Fund Research with Morningstar.

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