The rise of passive investing has been well documented with John Bogle’s Vanguard killing it this year. So has the decline of active management and high-cost mutual funds.
However, for the time being, active management is here to stay. While it would appear that the value of assets managed by active funds is shrinking at an alarming rate, the active fund management industry is massive and can sustain outflows of tens of billions of dollars for many years.
Indeed, according to Bank of America’s most recent Flow Show report, year-to-date passive ETS have attracted $52.5 billion in funds boosting assets under management by 2.4%. On the other hand, long only mutual funds have seen outflows of $180.2 year-to-date, which translates into 3.4% of assets under management. At this rate, it would take the active management industry decades to disappear.
Still, there’s no denying that the growth of assets following passive strategies has been explosive. Since 2009 investors have bought $961 billion of passive funds. At the same time, investors have pulled $592 billion from active funds. A recent report from Deloitte said that in 2015, 72% of money invested into funds went into those following a passive strategy.
There are many arguments for and against active management. The most commonly cited argument against active management is the arcane fee structure. Why should investment managers be paid 2% or more per annum when their performance lags the index?
The second most popular argument is that as most asset managers tend to like their benchmarks, it’s easier for investors to buy the cheap index fund and forget about everything else.
Perhaps for the average mom and pop investor, passive is the best way to go although it is an inherently lazy strategy and is yet to be tested in volatile markets.
The two main arguments against active investing, cost and performance are debatable. The argument is that active managers don’t earn their fees, but a considerable amount of evidence shows that investors themselves are to blame for the poor performance of active managers as they tend to switch in and out of funds at the wrong time. Moreover, passive strategies rarely tailor an investor’s portfolio to their specific needs. An active approach would be more suitable for an investor who wants to build a portfolio, which meets their goals and outlook.
Aside from the investor-specific factors analysts over at Bernstein believe there’s a much more sinister issue with passive investing.
Passive investing, worse than Marxism?
Active investors can be considered capital allocators. Financial markets are designed to improve companies’ access to capital and match investors (those with capital) to businesses that require additional funding (those who need capital).
Without active investors, passive investing will become the only capital allocation process and with no active investment we could end up in an environment that’s worse than a Marxist economy according to Bernstein’s team in a note titled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism” we are not joking.
In a Marxist economy, capital allocation is planned and the system is perfectly viable although it may be less effective than the capitalist model. However, a capitalist economy when the only form of asset allocation is through passive management could be considerably worse.
In the market ruled by passive funds, Bernstein’s research shows that the correlation of securities prices rises close to one. What’s more, stock prices become more correlated to the economic environment. Why is this bad? Well, the figures point to the conclusion that the more prevalent passive strategies become, the less relevant stock specific fundamentals become. As passive funds generally can’t pick and choose the stocks they invest in they have to invest in equities with no consideration of the fundamentals, which may lead them to buy securities no intelligent self-respecting investor would ever consider.
This could be good news for those companies that have terrible managements, high levels of debt and poor products, but is terrible news for capitalism as a whole as zombie companies will be kept alive longer and those companies that active managers would avoid will continue to find fans in the passive industry.
So while not exactly as he expected, maybe Karl Marx will have his victory at the end of the day!