Passive investment vehicles bridge the gap with active management

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Since the end of 2006, investors have withdrawn nearly $1.2 trillion from actively managed U.S. equity mutual funds and allocated about $1.4 trillion to U.S. equity index funds and exchange-traded funds. (AND F). When it comes to mutual funds and exchange-traded funds that buy U.S. stocks, those that passively track indexes now hold 48% of market assets according to Morningstar estimates. According to Bloomberg, passive funds will reach 50% in 2019 if the current trend continues. It would mark a tipping point for the investment industry, which for decades has built its stature on the prowess of stock and bond pickers seeking to beat the markets.

the morning star

One of the benefits of the growing trend towards passive investing is the lower costs for the investor. Not only do passive ETFs generally charge lower fees, but competition drives down fees among active managers. Sophisticated investors should look for active managers in low-efficiency, high-dispersion asset classes, and look to passive investing in the most efficient asset classes.

Below are the annualized net return figures for the past 20 years for the S&P 500 Index ETF (SPY), the Vanguard S&P 500 Index Fund (VOO), the S&P Real Index and the entire Morningstar Universe. of all national equity managers. Unlike school test grading, a fund manager universe ranking lists 1 as the best and 100 as the worst.

the morning star

the morning star

It is interesting to see the cyclicality of the swings. In some years, the index is in the 12th percentile, meaning the index beats 88% of active managers. In some years, the index is in the 72nd percentile, meaning that 72% of active managers beat the index. Index funds tend to follow the index closely, but underperform slightly due to the amount of fees and other fund costs.

There is another effect of a 50/50 mix of active and passive management. This 50/50 ratio effectively removes half of the purchasing power from the market. A good active manager may look for an attractive company with great fundamentals, but the passive half of the market doesn’t care about fundamentals and simply buys at all levels depending on the size of the company. Conversely, when investors turn bearish and decide to sell, they tend to move in groups, sometimes referred to as “the thunder herd”. When the herd abandons passive investments, the active half of the market may not be interested in buying the entire stock index and prefers to select those that are perceived to have good fundamental characteristics. Market concentration has increased, with passive managers being the largest shareholder in at least 40% of all US listed companies. In addition, this concentration raises concerns about new financial risks, including increased investor concentration and greater volatility in times of severe financial instabilities. There may indeed be opportunities embedded in this new risk, but what is clearer, we may experience increased volatility in the market in the future.

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