Although the basic commodity of ‘entertainment’ has remained the same, the way in which we experience it has greatly changed. From the days of only being able to view films in cinemas, to the emergence of VHS and DVD in the 80s and 90s, and finally to the online streaming services we see today, the wrapper that films come in has changed, but the product remains the same. Its transformations have been driven by three reasons:
We can see analogies to this in the world of investments. Although the fundamental principles of investing have remained the same, the wrapper, or the way in which investors access markets, has changed. In the past, it was normal for retail customers to phone up a stockbroker they trusted, and pay high commission fees to buy and sell single stocks. Industry trends then progressed to offering open-ended funds of actively-managed stocks to investors. More recently, a favoured approach for long-term investors has been to use easily-accessible, passively-managed funds. These often come in the form of index funds or exchange-traded vehicles, known as ETFs.
Since the first index fund was launched in late 1975 by Vanguard’s Jack Bogle, these passive funds have at the same time disrupted the industry, made investing more accessible, and reduced costs.
The question of whether they have enhanced quality is up for debate.
The passive and active styles represent the two ways to make money in financial markets. One is by investing in the long-term growth of the economy, i.e. new wealth creation that eventually flows through to capital markets – passive investing. The other is by exposing inefficiencies and trying to outsmart other market participants in the hope that their loss is your gain – active investing.
Passive evangelists would argue that there is no better way for long-term investors to compound their returns than by using low-cost trackers. They would also say that most inefficiencies in liquid markets are exploited too quickly by highly-developed quantitative algorithms for humans to have a meaningful impact. For longer-term investments, they would argue that the cost of research into these companies is too high for investors to see consistent excess returns. Even legendary active investor Warren Buffet has acknowledged the merits of passive investing and once said:
We can measure the benefits of passive, and the performance differences between passive and active funds, by looking at S&P’s Index Versus Active (‘SPIVA’) scorecards. First published in 2002, these are a quantitative review of how active managers in different regions performed against the broader index. The most recent annual scorecard for Europe published last month makes grim reading for active managers. For GBP-denominated funds the percentages underperforming their respective indexes over different time periods are as follows:
Source: S&P
The short-term numbers are not great, but over 10-years, higher fees in active management compound to make the picture even bleaker.
The Oracle of Omaha predicted this over 30 years ago:
We can see from our own analysis the effect of fees on a 10-year investment time horizon. The SPIVA comparisons are slightly unfair, as an index does not have a management charge (unlike real-life passive funds). They also assume perfect rebalancing and frictionless transaction costs. Perhaps a better comparison would be to compare two indexes net of passive and active fees. Here we look at the average OCFs of a range of passive and active multi-asset funds, which come out to 0.39% and 1.08% respectively. For a portfolio starting at £100,000, investing in line with a 60:40 equity:bond split would have yielded an annual return of around 8.04% gross of fees over the last 10 years. Net of fees, this would have resulted in a total value of £209k for the passive portfolio and £196k for the active portfolio at the end of the period – around £13k difference.
Effect of fees on passive and active funds
Source: AJ Bell Investments
But perhaps an even more pertinent question to ask would not be whether an active fund will outperform over long time periods, but whether it would still be around at all. The SPIVA reports also measure and account for survivorship bias. They found that for the same sections of GBP-denominated funds, only around half last for 10 years or longer.
Source: S&P
Given the benefits of passive investing, and the difficulties that active funds face, it should be no surprise that most investment flows have been in passive strategies for the last 10-15 years. New data published by Morningstar also shows that in 2023, passive assets under management overtook active for the first time since records began in 1993.
However, this raises another interesting question. Is the rise of passive investing ruining markets by destroying price discovery? Mike Green, portfolio manager and chief strategist at Simplify Asset Management, sums this up in two sentences:
Green’s argument is that passive flows cause investors to buy and sell with no regard for fundamentals. According to Green, this passive bubble has given rise to stock markets with exaggerated boom and bust cycles, as the influence of active managers in steadying prices driven by passive flow has waned. He estimates that passive indexing now accounts for more than 50% of buying in the S&P 500.
But it’s unclear at what level of concentration this would break markets. And this argument also rests on the assumption that active managers are trying to find fair value in company share prices rather than following other trends, such as momentum or arbitrage strategies.
Green also talks about what he calls “the uncanny valley”, a phrase more closely associated with the robotics industry whereby people experience an unsettling feeling when encountering an android with human simulations that aren’t quite realistic. In a similar way, Green says that we know something is wrong with markets, but we can’t quite put our finger on it.
Exchange-traded funds, or ETFs, may give investors some reassurances about the systematic threat of passive funds. While index funds interact directly with the shares they hold, ETFs have a secondary market mechanism where investors can directly buy and sell units of the ETF with each other. Around 80% of ETF trading occurs on this secondary market, with only around 20% hitting the underlying market. ETFs and index funds operate differently as ETFs will trade intraday while index funds typically target a VWAP or close price.
Additionally, a report from UBS in 2019 addressed some of this by claiming most of these concerns are raised by active fund managers – a naturally biased source. The UBS report claimed that, although passive funds own an increasingly large part of the market, active investors trade more frequently and with an individual view on securities.
The construction of index methodologies also differs in the extent to which they are able to mitigate negative effects from passive flows. The S&P uses committees to screen inclusion into indexes whereas MSCI uses a much more rules-based approach. For example, the S&P 500’s profitability criteria provide some insulation from blind passive buying of ‘bad’ companies.
Elsewhere, some active investors are optimistic about the rise of passive. Theoretically, wider price dispersion from fair value could provide greater opportunities for them. Passive investors subscribe to the efficient market hypothesis (EMH), a theory closely associated with the academic Eugene Fama, which states that all information is already priced into stock markets. Active investors have their own version of this theorem – the Grossman-Stiglitz Paradox. This states that, if EMH were true, there would be no profit incentive for anyone to do any research or information gathering to inform efficient markets, therefore it is an impossibility.
An interesting area for active investors could be those unloved, less liquid areas of the market, such as European value stocks. These are currently running at historically low valuations, despite naturally paying a high dividend yield as well as high buyback yields, taking the total running yield of the index to around 8%. What is more interesting is that the ratio of valuations for MSCI Europe ex UK as well as MSCI Europe Value against the S&P 500 is also at a historic high, at around 1.5 times and 2.2 respectively. In fact, the ratio between the US and broader market Europe ex UK index has never been higher.
Source: Morningstar
Source: Morningstar
These low valuations, coupled with a low-liquidity environment, could provide a good opportunity for active investors should market sentiment change and passive flows change with it. Currently the Eurozone’s market cap to money supply ratio is around 2.9, compared to the US where it is around 0.5. For context, the UK’s ratio is about 1.3.
Source: Morningstar
However, David Einhorn, hedge fund manager and founder of Greenlight Capital, is cautious about any optimism in markets for active investors. He warns that passive investing has simply lengthened the runway for stock price reversals and therefore active managers need to adapt by pushing out their investment time horizons to become longer-term.
The value of investments can go down as well as up and your client may not get back their original investment.
Past performance is not a guide to future performance and some investments need to be held for the long term.