The Case – Passive Management
The passive index fund is the most successful financial innovation in modern history. No question.
It is notable however that passive pioneer, Jack Bogle wrote that it would not “serve the national interest” for index funds to own more than 50% of the stock market (half of funds and ETFs are already passively managed). At which point, their impact starts to become too big for the market’s good3. That’s because, the thinking goes, an efficient market only works if there are both buyers and sellers, who hold different opinions on a share’s value. This breaks down when there is no one on the other side of the transaction, and no one is doing active research to uncover information about companies’ true worth.
For investors, total market exposure is crucial. Over the last 90 years, roughly 4% of US stocks accounted for all that market’s net wealth creation. The remaining 96% collectively generated gains that just matched the return on Treasuries over that period. Incredibly, only five stocks (Exxon Mobile, Apple, Microsoft, GE, and IBM) accounted for a colossal 10% of all that created wealth4.
The point being, you need to have total market exposure to avoid missing an Apple, an Amazon, or whatever the next behemoth of the future will be. What you do not need is an active manager to provide it. It’s an (almost) free lunch, so don’t overpay for it.
Passive strategies are evolving. Investors should include the more sophisticated products now available. Most are still built on the same model originally developed in the 1970s, which rebalance on the market cap (ie: size) of each share in the index. Newer, multi-factor strategies can be made to work even harder by tilting toward stocks with favourable characteristics (e.g: cheap stocks, low-risk stocks, stocks with wind in their sails, etc). This has been seen to boost performance and achieve better diversification, whilst maintaining incredibly low costs.
Since the Global Financial Crisis, ultra-low interest rates and a massive increase in the money supply have helped reduce the downside risk of stock investing, so far.
In this ecosystem, the traditional business model of active managers has suffered increasing pressure. The attack on their value proposition will not get any easier as investors focus on the attractive net-of-fee performance, and growing sophistication, of passive management.