The massive migration of assets from actively managed equity funds to index funds has attracted a lot of attention lately.1-6 The discussion varies, including worries about the future of active managers, concerns about market efficiency, and claims that active managers are about to outperform, and a variety of social impacts caused by this trend.
The flow of assets among U.S. equities is massive and may be a sea-change inflection point in the financial markets. The transition toward indexing has accelerated in the U.S. as more and more professional investment advisors have finally acknowledged the failure of active management. New Department of Labor fiduciary rules also make it more difficult for investment advisors to recommend active managers without exposing themselves to potential litigation risk. Figure 1 from a recent Wall Street Journal article, using data from Morningstar, shows the accelerating trend.1 Similar trends are occurring more slowly among bond funds and international equity funds.
Many articles, mostly wishful thinking from those selling active stock picking, suggest the “performance pendulum” will eventually swing back in favor of active managers outperforming. John Rogers, a highly respected portfolio manager for the Ariel Funds, recently captured active stock pickers’ common sentiment about active versus passive management.
“This is going to be the decade for stock pickers. … It’s been a long trend we’ve gone through where active managers have underperformed. We know in 30 years of doing this … we have gone through these waves. Things become very popular, very hot and everyone follows that concept. What’s worked yesterday gets everyone excited and people give up on what’s not working and often that’s where the opportunities are.” 6
Barron’s seems to be hot on this idea, with multiple articles suggesting active stock picking will make a comeback.7,8 Perhaps they’re nostalgic for the investing world of the 1980s and 1990s when stock pickers were the investment stars.
A much talked about research piece out of Sanford Bernstein, titled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism”, lamented a world where indexing dominated the markets.4 Figure 2 shows the parabolic rise in the number of indices used to track various slices of the markets.
As an active asset class trader, these charts do pique interest. Massive flows can be a source of alpha,9,10 and parabolic charts are always worth investigating, as a potential blow-off top can set up long-duration trends elsewhere as a bubble deflates.
Throughout the years I’ve seen active managers make a variety of arguments justifying the return of stock picking. Their theses revolved around an expected increased stock performance dispersion, falling correlations and higher expected volatility. In a recent article on the Barron’s website, Sarah Max suggests active managers can do better in a rising rate environment.8 Other claims suggest active management will show its value when the next bear market emerges, or if governments would just stop manipulating the markets. I’ve found these arguments unconvincing.
The idea active managers promote now is that the “pendulum” towards passive investing has swung too far. Figure 1 and Figure 2 do seem to indicate speculative activity. This argument is interesting because it seems analogous to what happened in 1999 to 2000 when U.S. large cap growth stocks became too popular, value shops were closing their doors and massive equity flows were chasing technology mutual funds. Most remember the pendulum swinging way too far towards growth stocks, which set up a subsequent large multiyear period of value dominance. Interestingly at that time, indexing was becoming quite popular, but at that time indexing meant just investing in the S&P 500 Index Fund. When the bubble cracked in 2000, the S&P 500 subsequently underperformed almost all asset classes for the next 10 years.
The argument that active equity fund managers are about to embark on a multiyear run of outperformance is somewhat interesting, but it’s not going to happen. Why? The mechanisms to support a multi-year run of active stock picking success are just too weak at this point in time. Here are four problems with this argument.
1: Too many active U.S. equity fund managers
There are still too many managers picking stocks with trillions of dollars of firepower. Although actively managed equity mutual fund outflows have been large the past few years, market appreciation has buffered losses due to outflows. Figure 3 shows the rising share of indexing up to the end of 2015.11 A year ago, index funds made up 34% of the market share among U.S. equity funds. This number is likely higher now – I guestimate about 38%.
To give a general idea of the relative sizes, the U.S. total equity market cap is currently about $25 trillion.12 Using data from Bogle11 and Figure 1, I estimate active U.S. equity mutual fund managers control about $8 trillion and indexing about $5 trillion as of the end of 2016. Hedge funds manage about $3 trillion, of which I’ll guess about $1 trillion is devoted to U.S. equities.13 The rest (about $11 trillion) is likely made up of individual stock ownership via old-fashioned brokers and investment advisors, and to a lesser extent stock-picking hobbyists. Foreign ownership (likely via foreign mutual funds and ETFs holding U.S. stocks) probably makes up a few trillion. These numbers are rough estimates, generally in line with government statistics.12
While it appears U.S. active equity mutual fund assets are peaking, only about 20% of U.S. market cap is passively managed. I’d guess 20% is nowhere near the fraction required to start interfering with price discovery. Only when this number gets north of 50% would I start to investigate potentially emerging anomalies.
In addition, hedge fund assets have grown by a factor of 10 since 2000, and one could argue the most talented stock pickers of this generation have gravitated to these firms over the years. Hedge fund assets seem to be peaking around this time as pension funds have also become fed up with poor performance and high management fees.
In summary, there are still too many smart active management firms competing with each other to generate superior returns, which generally means low excess returns for everyone. Active shops and hedge funds closing their doors in droves would be a signal, but the active management industry is still too profitable for that to happen anytime soon, despite all the evidence active management doesn’t work well.
2: Stock-picking tools for beating market indices are too limited
Benchmarks are much more sophisticated now. In the old days, active managers could beat the S&P 500 by systematically taking more risk – tilting towards small cap and value stocks. This trick worked when the S&P 500 was the benchmark. Now low-cost ETFs are available for all the equity tilts known by the industry – in addition to small and value, these tilts include momentum, quality, profitability, low-volatility and more.
How is a modern U.S. equity portfolio manager, confined to a style box, expected to outperform a style box index? Why allocate to an actively managed fund when a similarly exposed ETF is available cheaply? I suppose there are still factors to be discovered, such as the use of “big data” for choosing stocks, but I’d expect active managers and hedge funds to arbitrage away most of the alpha associated with this new information.
3: The zero sum alpha game hasn’t changed
For every active manager winning versus the index, there must be active portfolio manager losers. Active management can win across the industry only if active managers systematically exploit a large group of “dumb” investors. But a new group of dumb investors hasn’t emerged. Possibilities include foreign investors, retail investors, brokers, investment advisors, and possibly price-insensitive government owners.
Individuals and brokers seem like an ideal source of alpha for active managers. Back in 1970, households owned 80% of all stocks.12 This percentage has trended down to about 40% over the decades as individuals and brokers have chosen to use professionally managed and index mutual funds. However, during this time, active management failed to add value after fees.14-16 Hedge fund assets, which are much more focused on finding and exploiting pricing anomalies, haven’t fared much better in aggregate.
Interestingly, the indexing trend could help market pricing for many years to come if dumb investors are shifting to indexing.17 The flows from active towards indexing are still too strong and will not subside anytime soon. The new fiduciary rule imposed on brokers, and pension fund allocation trends, should fuel flows for many years to come.
The bottom line is that while assets managed by active mutual fund and hedge funds are likely peaking, dumb investor assets are already decreasing. For active management to win, the opposite is needed – lots of dumb money and few arbitrageurs.
The story is different for bond funds and for asset class traders. Bond indices are not as clean as equity indices. Bond indices suffer from a number of flaws, such as overweighting debt associated with the most indebted nations. Central banks have also manipulated yields to very expensive levels to combat the 2008 to 2009 banking crisis and the current low-growth environment. The potential for massive alpha generation across the bond fund industry has merit.
Asset class traders are probably unaffected by the indexing trend at this point because pension funds, brokers and investment advisors are now trading among index funds depending on which asset class appears attractive to them. This is a source of alpha for asset class traders since these market players tend to chase returns.
4: Selecting the winners is challenging
It’s still extremely challenging to select from all the active managers.14-16 It’s easy to know who outperformed in the past, but practically impossible to select future outperforming managers. All the money flowing to index funds has not changed this conundrum.
Is There a Trade Associated with this Strong Trend?
The active versus passive pendulum may be slowing down, but it’s still swinging towards passive. Here are a few thoughts on what could cause the pendulum to finally swing towards active management.
- Active managers must continue to reduce fees, perhaps associated with the introduction of actively managed ETFs.
- Active mutual and hedge fund managers closing shop.
- Index fund assets greater than 50% of the market. As indexed assets grow, reconstitution costs will begin to bite into returns. Hedge funds have exploited these motivated buying/selling events for years, especially as index assets have become such a huge part of the market. The impact on Russell 2000 performance is already significant.18 Perhaps active management will eventually win for the sole reason that they are not forced to trade stocks entering and exiting an index on a single day.
As ETF assets grow, look for poorly designed indices and ETFs to exploit. Target those with lots of assets, high turnover and/or illiquid underlying holdings, or those modeled around niche and trendy subsectors. Modeling reconstitution events – what stocks will be added and deleted from various indices – should be a growing alpha source. Also, searching among stocks pushed out of indexes due to non-investment reasons can potentially add value, such as stocks priced below $1, those coming out of bankruptcy, or those with too low a trading volume.
I wish Vanguard was a publically traded stock. That would have been a very nice pure-play on this trend.
As a long-term investor, don’t fall for the sales pitch. Investing in a diversified portfolio of index funds is far superior to picking among active managers. An even better option is to invest in funds that provide exposure to the markets cheaply, but do not follow an index. Dimensional Fund Advisors (DFA) has pioneered this approach of providing exposure to equities. I expect the long-time historical performance edge associated with the DFA equity funds versus index funds to remain robust as more assets flow from active to passive funds over the next decade.
- Dieterich, C., “Year in Review: 2016 Saw Record Flows to Index Funds”, Wall Street Journal, December 29, 2016. http://blogs.wsj.com/moneybeat/2016/12/29/2016-saw-record-flows-into-index-funds-and-out-of-active-ones/
- Tergesen, A. and Zweig, J., “The Dying Business of Picking Stocks”, Wall Street Journal, October 17, 2016. http://www.wsj.com/articles/the-dying-business-of-picking-stocks-1476714749
- Jaffe, C., “Opinion: Bill Ackman actually had a point with his index fund bubble theory”, MarketWatch, January 31, 2016. http://www.marketwatch.com/story/bill-ackman-actually-had-a-point-with-his-index-fund-bubble-theory-2016-01-30
- Kawa, L., “Bernstein: Passive Investing Is Worse for Society Than Marxism”, August 23, 2016. https://www.bloomberg.com/news/articles/2016-08-23/bernstein-passive-investing-is-worse-for-society-than-marxism
- Siegel, L.B., “A Prediction for the Future of Active Management”, Advisor Perspectives, January 2, 2017. http://www.advisorperspectives.com/articles/2017/01/02/a-prediction-for-the-future-of-active-management
- Burr, B.B., “Market’s post-election moves leave little room for bargain hunting”, Pensions and Investments, November 21, 2016. http://www.pionline.com/article/20161121/ONLINE/161129973/markets-post-election-moves-leave-little-room-for-bargain-hunting
- Norton, L.P., “Active Stockpickers Are Outpacing Passive Funds”, Barron’s, November 5, 2016. http://www.barrons.com/articles/active-stockpickers-are-outpacing-passive-funds-1478318812
- Max, S., “Return of the Stockpickers”, Barron’s, January 10, 2015. http://www.barrons.com/articles/return-of-the-mutual-fund-stockpickers-1420870199
- Tilley, D., “Follow the Flows”, Asset Class Trading Blog, Sept 29, 2015. http://www.assetclasstrading.com/2015/09/29/follow-the-flows/
- Tilley, D. “Follow the Flows – The Last 20 Years”, Asset Class Trading Blog, October 16, 2015. http://www.assetclasstrading.com/2015/10/16/follow-the-flows-the-last-20-years/
- Bogle, J.C., “The Index Mutual Fund: 40 Years of Growth, Change, and Challenge”, Financial Analyst Journal, January/February 2016, p. 10.
- Ned Davis Research, Charts NDR-S702, NDR-S0483. ndr.com.
- Barclay Hedge. http://www.barclayhedge.com/research/indices/ghs/mum/HF_Money_Under_Management.html
- Bogle, J.C., Common Sense on Mutual Funds, 2009.
- Jenson, M, “The Performance of Mutual Funds in the Period 1945-1964”, Journal of Finance, May 1968, p. 414.
- Carhart, M.M., “On Persistence in Mutual Fund Performance”, Journal of Finance, March 1997, p. 1.
- Philosophical Economics, May 1, 2016. http://www.philosophicaleconomics.com/2016/05/passive/
- Reed, A.V., The Life Cycle of an Arbitrage Opportunity: Reconstitutions of the Russell 2000, Working Paper, August 2000. See also Russell Research Commentary, “Price Pressure at Russell Index Reconstitution”, April 2007 and references included.
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