The most profound developments in the investment markets in the last 20 years have been the growth of indexed-based investing and the move to passive fund management. Though the assets of mutual funds have increased three-fold in the last 17 years, the assets of exchange traded funds (ETFs), funds that are typically indexed, have grown 130-fold.[1]

The growth is not just in ETFs. Index mutual funds have grown in assets over this same period six-fold.[2] Index funds make up 22% of all mutual fund assets currently.[3] In contrast, in 1994 index net flows (purchases) were only 2% of all net new cash in domestic equity funds.[4] For every $1.00 that has abandoned actively managed domestic equity mutual funds since 2007, $1.20 has gone into domestic equity index funds and ETFs.[5]

Indexed-Based Investing

Indexed-Based Investing

Investment Company Institute. 2016. 2016 Investment Company Fact Book: A Review of Trends and Activities in the US Investment Company Industry. Washington, DC: Investment Company Institute. Available at www.icifactbook.org.

Within the last 10 months we have achieved a trifecta in trillion dollar milestones: April 2016 – ETF assets reached $3 trillion, October 2016 – Blackrock assets reached $5 trillion, February 2017 – Vanguard assets reached $4 trillion.

This dramatic growth offers significant opportunity for the index fund industry, but not without its risks. As assets move from active to passive management, what systemic danger lurks? What market disruptions might occur with a concentration of assets backed by monolithic indexes on autopilot? Are there liquidity risks? Are the risks safely contained within financial services, and, more specifically, the investment industry? Or, is this a ubiquitous risk that could threaten your company, and indeed the entire economy? Could this hyper-growth portend a market failure as broad and damaging as the financial crisis of 2007-2008?

Perhaps because of the inchoate nature of the index-growth phenomenon, market watchers have expressed a wide variety of opinions from “not an issue,” to an intriguing Sanford Bernstein & Co. report that warned “passive investing is worse than Marxism.”

The battle has many fronts, and no resolution.

Active or passive management

The dispute starts with the structure and returns of indexed mutual funds and ETFs, and differences with active management. Indexing is the rote emulation of a fixed benchmark; active management is the attempt to outperform the benchmark with superior securities selection or timing. There have been winners on both sides, but the evidence is that indexing in the aggregate has outperformed active management.

Data from the S&P Indices versus Active U.S. Scorecard (SPIVA®), which has been published for 14 years, shows in detail the fortunes of active managers against their benchmarks. “(O)ver the 10-year investment horizon, 85.36% of large-cap managers, 91.27% of mid-cap managers, and 90.75% of small-cap managers failed to outperform (their benchmarks) on a relative basis.”[6] The same underperformance held for active fixed-income managers, though they generally performed better against their benchmarks than active equity fund managers.

Studies from Morningstar Inc,[7] and BNP Paribas[8] have shown similar results. Generally, for long periods, index investing has outperformed active investing in total returns after costs. However, investment advisors still build the case for active management when they use managers who have shown superior performance over long periods – and there are many – who invest in areas that indexes have not yet reached, or cite the value-added benefits from active managers for their research and other services. With the explosive growth of indexing, the concern remains; How will the securities markets behave if it is one day predominantly driven by automatic purchases and sales tied to the fixed rules of similar indexes?

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

By Andy Martin, read the full article here.