Author: Brian Gorman
July 27, 2022
Passive funds, which track indices such as the S&P 500, are gaining market share worldwide as investors become more reluctant to pay the higher fees demanded by active fund providers. The perspective of the private investor best illustrates the appeal of low-cost funds. A fund’s charges are often a barrier for those with not much to spend. For example, an investor putting $10,000 in an equity fund may suffer a loss if the companies perform poorly. But if he has to pay a fee of one percent, this will reduce his wealth by a further $100.
Active funds pay a fee to help cover the salary of managers, in some cases high-profile figures, for the benefit of their skill in picking the right investments, such as stocks. This may involve researching companies, which can be costly. Passive funds, also known as trackers because they track an index, incur no such expense. BlackRock, Vanguard and a host of other asset managers have been offering low-cost trackers for decades. However, in recent years, the competition to lower fees has become even more intense, due to a combination of regulatory pressures and more products coming onstream. The Ongoing Charges Figures (OCF) for some of the major trackers is just 0.07 percent, and in some cases even lower.
Performance data is also boosting the case for passives. It shows that the vast majority of active funds are repeatedly failing to outperform their benchmarks. The Standard & Poor’s Index Versus Active (SPIVA) scorecard spells out the statistics. It looks at thousands of active funds and how they have performed compared with their benchmark. In 2021, large-cap funds continued their underperformance for the 12th consecutive calendar year, as 85 percent of active large-cap funds trailed the S&P 500.
Fund managers often respond to evidence of active underperformance by claiming to offer better returns after adjusting for volatility, reports SPIVA, but add: “This would be an appropriate counterargument, if only it were true.”
Hundreds of passive funds are available covering specific sectors or themes
SPIVA said the vast majority of actively managed funds underperformed over the long term even after allowing for risk. SPIVA cited data based on the S&P Composite 1500, which covers approximately 90 percent of US market capitalisation. Among domestic equity funds, while 90 percent have underperformed the S&P Composite 1500 over the past 20 years, an even greater 95 percent did so on a risk-adjusted basis. For most investors, such as pension funds, the long-term investment picture is more important.
Fans of active management have frequently put forward the argument that passive funds have benefited from a strong run in recent years for world stock markets. The S&P 500 regularly hit new highs in 2021. The rising tide that has lifted nearly all ships makes it more difficult for active funds to demonstrate their value and how they cope better with downturns, say active proponents.
However, the temporary downturn and the volatility brought on by the pandemic should have provided the perfect opportunity to show actives in a better light. The evidence says actives failed the test. Proponents of active funds may argue that a deeper, more prolonged downturn will help their case. This theory could soon face a fresh test, with the S&P 500’s sharp downturn in the spring of 2022.
SPIVA’s data is slightly more encouraging for active bond funds. Bond prices have fallen sharply with central banks around the world signalling the end of quantitative easing, and raising interest rates. Many benchmark bond indices were in negative territory for 2021.
The most notable success for actives was in funds of US government bonds with longer maturities: about 82 percent outperformed their benchmark, the Barclays US Government Long index. For short and intermediate maturities, the proportions outperforming were 26 percent and 52 percent respectively. On the face of it, this might give some hope for the active case. But the outperformance was short-lived.
For example, with the Barclays US Government Long index more than 95 percent of actives underperformed over three, five, 10 and 15 years. This is also a familiar pattern for some equity funds, which outperform in the short term, but fail to sustain this performance over longer periods.
The cautionary tales of high-profile fund managers falling from grace also boost the case for passives. For many years, London-based fund manager Neil Woodford was highly regarded for the returns he achieved at Invesco. However, when he left to set up his operation, Woodford Investment Management, disaster ensued. He had to close down the company after investing heavily in unlisted, illiquid companies. Investors suffered heavy losses.
Short-term outperformance is, to some extent, part of the laws of statistics. If thousands of players throw a dice twice, you can expect one in 36 of them to throw two sixes. Extend the exercise to three throws, and only one in 216 will throw a six every time. Go to six throws, and it’s one in 46,656. Active proponents will argue that a fund manager is engaged in skill, not a game of chance. But most don’t seem to have the skill to outperform.
Efficient markets hypothesis
What makes outperformance difficult, in some ways, is the phenomenon known as the Efficient Markets Hypothesis (EMH). This is the theory that the prices of shares, and anything else widely traded such as bonds and currencies, already have all relevant information, such as profitability and economic risk, priced into them. If a company’s shares are trading at $10, they are probably worth about $10, says EMH. If they were worth $15, investors would have snapped them up and forced the price up to $15. EMH is unlikely to apply to all tradeable financial assets all of the time, but may apply sufficiently to make prolonged outperformance difficult.
Even Warren Buffett, one of the world’s best-known active investors, has also helped the case for passives. The Sage of Omaha oversees more than $800bn in investments through his Berkshire Hathaway insurance company but has recommended that investors should put a large proportion of their money into an S&P 500 tracker, citing the low cost.
Investors seem to agree. Assets under management (AUM) in index funds accounted for 40 percent of the total AUM in the US, at the end of 2020, compared with just 19 percent 10 years earlier. This data, from Statista, also showed that Exchange Traded Funds (ETFs) had grown most rapidly and now accounted for the majority of US passive equity funds. Bloomberg Intelligence, meanwhile, says that in domestic US equity funds, passives have already overtaken active.
It forecasts that passives will have more than 50 percent of the total US market by 2026, possibly earlier.
For the providers, there remains a conflict. Companies such as Vanguard and BlackRock still have a sizeable active business and have no interest in seeing it disappear. The fees they earn from active products are much higher than from a passive fund of the same size.
That said, some of the biggest passive funds are very lucrative for the providers if they can achieve sufficient scale. State Street’s S&P 500 ETF has some $400bn in AUM. Even with fees as low as 0.07 percent, the revenue generated is in the hundreds of millions for the bigger funds. For institutional investors, investing is usually a combination of active and passive. As a spokesman for abrdn, an almost entirely active house, told World Finance: “There is a place for both active and passive investment approaches in a well-diversified portfolio and a combination of both can be beneficial in different market conditions.”
Investors can use passive funds to obtain basic market exposure. For example, they buy S&P 500 tracker products to gain exposure to US equities. To execute more nuanced stances on the market, they might then buy some active funds, or individual stocks, bonds and other instruments.
However, passives are increasingly making inroads at the more granular level. Hundreds of passive funds are available covering specific sectors or themes. This includes sectors such as mining, energy and information technology.
The theme of inflation
Trends and developments in the market might seem to offer active funds a chance to show their value. A major theme in 2022 is inflation. Some active funds argue they can better pick stocks that can navigate the dynamics by selecting certain shares. For example, they might buy into supermarkets on the premise that they are better able to pass on increased costs to customers, as they are selling essential items. Deborah Fuhr, founder of ETF data provider and consultancy ETFGI, told World Finance: “I don’t buy it. Every time something happens, they say this is the time for active management. Consistently, hedge funds and active mutual funds don’t deliver the alpha they tell people they’re going to do – why would I pay high fees when I could get better performance with a low-cost ETF?”
In any event, the raft of passives available to address the issue include ETFs of inflation-linked bonds, as well as ETFs of equities selected for pricing power. Fuhr also cited the recent popularity of products tracking the gold price, which some investors see as a hedge against inflation.
Trackers are now also addressing environmental, social and governance (ESG) issues, a massive theme on the investment landscape. Index compilers such as FTSE and MSCI are covering a vast range of issues: climate change, controversial weapons and labour practices, to name but a few. They have come up with an array of indices that are now being tracked by hundreds of low-cost products. Some products cover specific themes; others aim to cover the whole ESG spectrum.
Passive funds also include products based on smart beta. Smart beta strategies are those that have been shown to beat the market over a period of time by investing in companies with certain characteristics. This might include companies that pay higher dividends or have lower market volatility. Indices for such companies are compiled. However, unlike mainstream trackers, the index is based on the relevant theme rather than market capitalisation.
These strategies sometimes outperform, but sometimes disappoint. The dividend strategy struggled when many companies cut payouts during the pandemic. Sceptics will argue that if EMH really applies, they shouldn’t work at all.
The big picture is that passives have it covered. This includes emerging markets, where actives might appear to have an opportunity to discover hidden value. But SPIVA data shows that in emerging markets, as with other areas, short-term outperformance is simply not maintained.