As the active versus passive debate continues to drag on, analysts are increasingly looking at the effect the rise of passive investing is having on the market’s structure and the efficiency of capital markets.
It is impossible to deny that passive investing and products that follow a passive strategy have been the greatest success story in the financial world since the financial crisis. According to research from Bank of America, since December 2008 passive funds will have attracted a cumulative $1.6 trillion in funds by early next year compared to active funds, which have seen cumulative outflows of around $400 billion between the end of 2008 and the second quarter of 2016.
- John Authers And Bill Sharpe Talk Passive Investing And Financial Models
- The Active-Passive Investing Debate Revisited
- How Passive Investing Creates Concentrated Portfolios
Despite the enormous volume of cash flowing into passive funds, funds following active strategies still make up around two-thirds of assets under management within the fund management industry. Passive funds constitute 34% of industry assets under management, up from around 19% of the end of 2008.
Fund flows from active to passive strategies have been accelerating in recent years, and 2016 is currently shaping up to be the worst year on record for active managers. As shown in the chart below, almost $200 billion has flowed out of funds following an active strategy year-to-date more than last year’s total outflow of $150 billion, which was at the time a record in itself.
The volume of dollars flowing out of active strategies and into passive strategies is almost sure to cause some waves in the market. According to research from Bank of America posted the end of last month, this is exactly what is happening.
Passive investing is hurting the performance of active managers
Passive funds, especially index trackers which generally tend to attract the most funding for investors, have almost no control over the stocks they can buy. There is no consideration given to a company’s fundamentals, which is partly the reason why passive funds have generally been able to outperform active managers over the past few years. And because of the sheer volume of money moving into passive funds, this performance is likely to continue.
Bank of America’s research shows that year-to-date a strategy selling the ten most overweight stocks held by active funds and buying the ten most underweight equities has generated 12 percentage points of alpha compared to the S&P 500. This outperformance makes a lot of sense.
Active managers generally chase the companies with the most impressive fundamentals and ignore companies with deteriorating outlooks. On the other hand, passive funds have no choice and buy across the board. Therefore, passive fund flows are supporting the market’s most hated companies. Active managers’ ten most underweight stocks have returned 16% year-to-date. As shown below, the same trend emerged in 2015 and 2014.
The underperformance of the most loved stocks by active fund managers isn’t anything new. Buying unloved stocks is the basis of contrarian and value investing. Still, it’s worth keeping an eye on how passive investing is shaping the market. The majority of passive funds ignore fundamentals and overtime this is bound to have an impact on capital markets.