Passive Aggressive

The rise of passive investing has been the dominant narrative in asset management over the past decade, driven by the rise in popularity of ETFs and tracker funds. As investors have lost faith in the skill of fund managers to consistently generate alpha net of fees, capital has poured into these low-cost vehicles, designed to track benchmarks instead of seeking to beat them.

The numbers speak for themselves. Some $4.6tn was held in ETF assets globally at the end of 2018, up from less than $100bn at the turn of the century. Passive funds made up 45% of AUM in equity funds and 26% for bond funds. Clearly, this has huge implications for investors but also for all capital markets participants.

Why is passive taking over the world? Its intellectual genesis dates back to the formulation of the Efficient Markets Hypothesis in the 1960s. By questioning the ability of managers to beat the market, EMH seemed to imply that investors would enjoy better results by simply mimicking the market itself. By the 1970s, the technology had caught up, and the first stock index funds made passive investing a viable alternative to traditional stock pickers in their ivory towers. Since then, increased regulatory oversight with regards to fees has forced the investment industry to adopt low fee structures that can scale rapidly across the retail investor base.

From an investor perspective, the high costs of active management (incurred through an opaque combination of management, performance, brokerage and custodial fees) exist against a backdrop of ever plummeting costs for index funds. The result? An awesome wave of global capital has flowed into passive investment vehicles, and this shows no sign of abating.

This trend is creating a feedback loop that is seemingly unstoppable. As John Authers has pointed out, “whatever active managers do, an index of the market will do better than the average active manager. This is because in the current world of institutionalised asset management, the sum of all managed funds grows ever closer to the sum of the market.”

The shift to passive has inspired countless articles, arguments, new ventures, bankruptcies, you name it. One blog post cannot hope to encircle this massive subject, but I wanted to draw your attention to a fascinating experiment, one which highlights the perils of arguing against the passive movement.

In 2007, Warren Buffett made a $1m bet with Protégé Partners, an asset manager, that an index fund would outperform a collection of hedge funds over the course of the next decade. It probably won’t surprise you to hear that Buffett won the bet. But the manner of his victory was startling.

Over the ten year period, the S&P 500 index fund returned 7.1% compounded annually, significantly more than the average of 2.2% returned by the basket of funds selected by Protégé Partners. Buffet pointed out in his annual letter to shareholders, “Making money in that environment should have been easy. Indeed, Wall Street “helpers” earned staggering sums. While this group prospered, however, many of their investors experienced a lost decade. Performance comes, performance goes. Fees never falter.”

I find the Buffett bet particularly interesting because it brings the “passive vs active” debate alive with a tangible example of how fees can eat away at returns. It seems particularly timely now, given the recent shakiness in markets and the huge focus on passive investing.

Of course, passive investments are yet to be truly tested by a prolonged market downturn, as the going has been good since the global financial crisis in 2008. It remains to be seen whether another crisis – or a drift downwards in valuations – could precipitate a return to active investing, where volatility is lower and risk management tends to be regarded as more sophisticated.

The takeaways from Buffett’s bet are well known now amongst the investor community and explain the multi-year strength in ETF flows and the ongoing struggles of the hedge fund industry. Hedge funds continue to go through a very public midlife crisis, whilst ETFs stand strong. Q4 2018 was particularly unpleasant, with many active managers licking their wounds going into 2019. Fees are falling, in some cases, collapsing. Gone are the days of funds launching with 2/20. Now it’s more like 1/10, and that’s if they’re lucky.

Where do we go from here? Are we witnessing the death of the hedge fund? I’m not so sure. The success of the passive movement might actually offer an opportunity for savvy active managers to gain market share. As markets become more automated, correlated, volatile, there will be an increased need for active managers who use a combination of human imagination and technological expertise to better manage risk. As with natural selection, the best will adapt to their environment and come to thrive in a world dominated by passive investing.