Introduction
of certain industries in today’s environment, active management underperformance has proven to be a cyclical
phenomenon, and we are fairly certain that active management will demonstrate outperformance in the coming
years.
Passive Investing Continues to Attract Fund Flows
The amount of assets invested in passively managed investment products continues to increase. A
number of factors are contributing to the growth of passive investing, including increased fee disclosure, investor
awareness of active management outperformance (or lack thereof), proposed/pending regulation holding
advisors to a new higher standard when managing client assets, and increased traction for roboadvisors.
According to the Investment Company Institute, actively managed domestic equity mutual funds have had
outflows in every year from 2005 to 2016, while index domestic equity mutual funds and ETFs had inflows in
each of these years. As a result of the strong inflows garnered by passive investment strategies, the percentage
of equity assets managed within passive strategies has increased from approximately 10% in the late 1990s to
nearly 40% today, according to Credit Suisse (which defines all rules-based active management strategies,
such as smart beta and other factor-based indexes, as passive).
Percentage of U.S. Equity Assets Under Management (AUM) in Passive
Notwithstanding the recent outperformance that active managers have enjoyed since November 2016,
the robust flow of funds into passive strategies has proven to be a particularly strong headwind for active
managers (especially those who employ a value discipline). Many passively managed products such as index
funds and index ETFs are market-capitalization-weighted vehicles and therefore tend to buy more shares of
securities that have done well and that thus likely have higher valuations than companies with lower weightings.
Clearly, there is not a direct correlation between the absolute weighting of a security in a passive product such
as an S&P 500 index fund or ETF and its valuation (e.g. Apple has large weightings in a number of indices and
ETFs, but, many observers do not believe its valuation is stretched), but as money flows into index funds, the
stocks that have done well are propped up even further, reflecting the “buy discipline” of these fund structures.
The discrepancy becomes pronounced during bull markets and is a key contributor to the strong
underperformance of active managers (both value and growth) whose portfolios tend to deviate materially from
those of the index.
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Introduction
Structural Advantages and Disadvantages of ETFs and Passive Investing
Clearly, we are very wary of ETFs and the risks that may be lurking behind the currently calm market.
But not all ETFs are created equal, and we would be remiss to dismiss the advantages offered by ETFs/passive
investment strategies—particularly as they pertain to the retail investor. These advantages include immediate
liquidity (for ETFs of scale), increased access to otherwise difficult-to-access markets (e.g., bonds, emerging
markets), reduced trading costs, and tax efficiency. But most important is the lower fee structure that is typical of
ETFs compared to traditional mutual funds and other investment vehicles. The average index fund charges just
0.11% annually versus 0.84% for actively managed funds.
1
Many retail investors also pay broker or advisory
fees on top of fund fees. Robo advisors fees are typically far below those of the RIA, brokerage, or hedge fund
model, and individual investors can easily create a diversified portfolio via ETFs without even using a
roboadvisor. Over a long investment horizon, the compounding effect of lower fees on growth in principal is
quite dramatic.
An obvious downside to investing in passive, broad market-indexed ETFs is that investors are generally
forgoing the ability to generate excess returns. However, in the simplest terms, and putting aside benchmarking
issues, by definition the average investor will not outperform the market. In reality, there is annual variability in
broad equity market returns achieved by different investor classes (individual direct brokerage vs. institutional,
mutual fund vs. hedge fund, etc.). But unsurprisingly, active U.S. equity funds, in the aggregate, have failed to
beat their benchmarks over the long term, as illustrated in the following charts. In fact, according to S&P’s latest
SPIVA Scorecard, an astonishing 92.2% of U.S. large-cap fund managers have trailed their benchmarks over
the past 15 years, on an asset-weighted basis.
2
The figures are similarly poor for mid-cap managers (95.4%
underperform) and small-caps (93.2%). Looking back over the past 20 years, at no point have >55% of funds
outperformed the market over any 2 consecutive years—even at the height of prior “stock picker’s markets”
(e.g., 2000-2002, 2007-2009).
U.S. Active Equity Funds: % Outperformed by Benchmark, Rolling 3 Years
Source: S&P Research
1
Ky Trang Ho, “How to beat 90% of mutual fund managers in the long run,”
Forbes
, April 12, 2017,
https://www.forbes.com/sites/trangho/2017/04/12/how-to-beat-90-of-mutual-fund-managers-in-the-long-run/#34f286984257.
2
“SPIVA statistics and reports,”
Indexology
, http://us.spindices.com/spiva/#/reports.
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