At all levels
Vanguard recently published a short article titled “MYTH: Active management performs better in certain market segments. » Taken literally, this statement is false. Regardless of the period, some active fund categories are doing better than others. For example, according to Morningstar’s Asset/Liability Barometer research, three times as many actively managed emerging market equity funds have beaten their benchmarks over the past 10 years as active broad-based US equity funds.
The title is also not quite accurate at the next level of abstraction. Not only do some active fund categories outperform others over a single period, but extending these studies also reveals some persistence. Emerging-market active funds routinely give indexers a stronger fight than large-combination U.S. equity funds. Smaller equity funds have more relative winners than blue chip funds.
But I accept the thesis at its highest level: regardless of the investments or their location, active managers face similar issues. They must overcome their cost disadvantage by outmaneuvering other market players. However, today’s participants are better prepared than ever, which means that active managers can no longer succeed by being very good or even excellent. To succeed, they must be exceptional.
The Vanguard document graphically supports this point. Ignore the red line in the diagram below; we’ll get to that topic shortly. Gold is what matters. It represents the number of candidates registered for the Chartered Financial Analyst exams. Admittedly, obtaining the CFA title is only a means of accessing investment training; it’s not like the industry was devoid of professionals before 1985. But without a doubt, the field has become more crowded.
The CFA effect was far-reaching. When the program started, it only taught stock analysis to Americans. This increased the level of investment competition for US equity funds, but left other investment categories untouched. Over time, however, the CFA Institute has expanded the program to cover bonds of all flavors, alternative investments, and asset allocation. It has also gone international. This year, 75% of CFA candidates live outside the United States. Wherever the financial market there has plenty of local experts.
The question then becomes: what are all these educated investors doing, when indexing has become so popular? After all, index funds require little CFA. They require careful operational attention and a portfolio manager to oversee results, but they don’t need research staff. The gold line on the chart appears to have headed in the wrong direction. As indexing has increased, the number of investment professionals is expected to decline.
Well, here’s the problem: indexing isn’t as widespread as is commonly believed. Last week, my colleagues circulated a 2017 report from BlackRock that I had missed, “Index investing supports vibrant financial markets.” (Now there’s a boring headline.) Rather than just looking at US public funds, which is typically how active management versus indexing studies are conducted, BlackRock measured how all of the assets of investment are deployed. And those numbers are…remarkable.
Going back to the Vanguard chart, the red line shows that since the early 1980s the percentage of US assets professionally managed has increased almost 80% from 40%. The pattern is similar outside the United States. One might think that the development is linked to the indexing boom. But this is not the case. On the contrary, the BlackRock article demonstrates that most of the movement of the red line is due to the growth of active management.
Within US stocks, BlackRock reports that 12.4% of market capitalization is held by index mutual funds and exchange-traded funds. (These numbers are from December 2016; they’re a bit higher today.) Another 16.8% is held by active funds, which means publicly registered funds hold just over 28% of the stock market. American. The remaining 72% operate largely in the dark, as there is only limited information about how these assets are invested. Clearly enough, however, most, if not most, of these funds are actively managed.
Active management is even more important when viewed from a holistic perspective. This forced BlackRock to make a host of assumptions; therefore, its estimate may be off by a few percentage points. But even so, the conclusion is unequivocal. BlackRock finds that less than 17.5% of global equities are indexed, either directly through funds or indirectly as part of an institution’s investment strategy. The vast majority are actively managed.
Moreover, these active assets affect stock market prices much more than indexed assets. Not only do indexers take the quotes the markets give them, rather than influencing prices by buying stocks the active manager finds attractive and selling those they don’t, but they are also much less likely to trade . Annual turnover for actively managed U.S. equity accounts is 80%, BlackRock writes, compared to 7% for the index average.
Indexing, rightly, is making headlines. For many years now, index funds have dominated the sell charts, with their rivals actively managed in net redemptions – a trend that shows no signs of abating. But indexation is not yet significant enough to distort financial markets. The challenge for active managers does not come from outside. It comes from within. It comes from the tens of thousands of investment professionals who have raised the skill level required to succeed in active management and the tens of thousands of new entrants who join the industry each year.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar generally agrees with the opinions of the Rekenthaler report, his opinions are his own.