Have we reached “peak” passive investing? Don’t bet on it

Passive funds (which just track an underlying market) are rapidly stealing ground from actively-managed ones (which try to beat the underlying market).

According to data from Morningstar, quoted in the FT, "assets managed in passive mutual funds grew 4.5 times faster than active in 2016". At this rate, reckons Moody's, passive could overtake active in the US by 2024.

Clearly, this is a worry to the active-fund management industry. Fewer assets under management means lower profits. And they're not taking it lying down.

Try 6 free issues of MoneyWeek today

Get unparalleled financial insight, analysis and expert opinion you can profit from.

Start your trial

Sign up for MoneyWeek’s free twice-daily newsletter.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Join more than 165,000 subscribers and keep yourself informed with latest financial news, insights and expert analysis to help you understand what really matters when it comes to your finances.

Sign up

Now, we're being told, it's active managers' time to shine...

Active investors are still circling the wagons

I started writing about passive funds, index trackers, and exchange-traded funds (ETFs) more than ten years ago. Back then they were still quite obscure (even though the first widely available tracker fund launched in the US in 1975).

The whole idea of these funds (and we'll set aside stuff like "smart beta" for now) is to give investors exposure to an underlying market, without trying to beat it. So a FTSE 100 tracker would simply give you the return on the FTSE 100, less costs.

An actively-managed fund aims to beat the market. At first glance, that sounds good. Why settle for the market return when you could get better by investing with a clever stock-picker?

In practice, it's not that easy. It turns out that most active managers can't beat the market consistently over the long run. Earlier this year, Standard & Poor's found that an incredible 92% of US large-cap funds had failed to beat their benchmark over 15 years and they charge handsomely for simply making the attempt.

The benefit of a passive fund is that it's much cheaper to run than an active one. If all you have to do is replicate the market, then you don't need to employ an expensive stock-picker. That means more of the underlying performance ends up with the investor.

So going passive gives you the best of both worlds you pay less, and you still get to outperform the majority of active managers while you do so.

It's taken a while for the message to get through. But a combination of regulatory changes, the rise of passive fund giant Vanguard (whose founder, Jack Bogle, created the first index-tracker), and relentless repetition of the message in the media has helped.

Today, the active management business is being disrupted horribly by the rapid growth of passive investment and its various offshoots.

Naturally, they're not happy about this. But like any complacent incumbent industry, many in the business are still trying to shore up their position, rather than embrace painful change.

In the US, reports Robin Wigglesworth in the FT, the Investment Adviser Association (an industry lobby group) is setting up "a council dedicated to defending active money management."

And now, the latest argument being made is that the environment is changing in such a way as to favour active fund managers. Rising interest rates and a drop in correlations (in other words, stocks aren't all moving in the same direction any more), make it easier for stock-pickers to outperform.

The underlying argument here and you can see it being made with increasing regularity is that active vs passive is a cyclical thing. Right now, we're reaching "peak" passive and it's time for active to take the lead again. You see variations on this theme when people write about there being an ETF "bubble".

Put bluntly, this is just industry bilge a crafty marketing tool. Here's why.

There is no "special time" to be an active manager

In the first half of this year, active funds have indeed made a bit of a comeback a full 54% of large-cap US equity funds managed to beat their benchmark, according to Bank of America.

So if you'd switched from passive to active at the start of this year (good piece of market timing on your part!) then you'd have a slightly better than "heads or tails" chance of having beaten the wider market.

And with any luck, the fund you chose will continue to outperform all the way to the end of the year, and maybe even beyond. Fingers crossed, eh?

Forgive me if I'm unenthusiastic. It seems that when active managers go through a period of short-term underperformance, then it's all about patience, and the long term. But when they undergo a period of long-term underperformance punctuated with a brief spurt of competence, then it's suddenly all about the past six months.

There's a word for this that I can't use in Money Morning, but you'll find a lot of it coating any rural bridleway in your vicinity.

The whole "passive vs active" debate is stupid anyway, in that it paints a whole range of wildly different investment tools with one label or other. But I want to keep this as simple as possible this morning, because these are the nonsense arguments you'll keep hearing over the coming months.

There's a beguiling false logic to the view that active managers will beat the market when it's falling, for example. The idea is that they can provide some sort of insulation for your money by carefully stepping outside of the market when it's falling, or being more defensive, whereas passive funds will just slide with the market.

But it's simply not true. Passive investment giant Vanguard looked at returns on active funds since the late 1990s to the present day, incorporating two bear markets (2000-03 and 2007-09) and three bull markets (1998-2000, 2003-07, and 2009-16). The findings? Bull or bear market, "there is no evidence of active managers systematically adding value."

And if you think about it, that makes sense. Why would the average active manager be any better at timing a bear market than a bull market? How do they know when to go defensive and when to stay aggressive?

It also misses the key point of going passive in the first place: if you can predict the right time in the cycle to change to an active fund, and you can also choose the right active fund to be in at that point (remember that nearly half of them still underperformed this year), then why aren't you using psychic powers to pick your own stocks?

There's a case to be made for individual active funds, but this isn't it

I'm not saying that you should never invest in any active fund. Some active funds are a lot better than others, and some will do better in certain market environments.

Nor is choosing these an entirely random process. There are good active funds, with decent incentive structures and focused strategies that are definitely trying to do something different to the underlying index.

These funds may deserve a place in your portfolio as long as you can understand what they do, what they cost, and why you might want to own them, rather than a passive alternative.

Nor am I saying that you should have all of your money in passive equity funds right now (markets are very expensive, so that's definitely not what I'm suggesting).

But as things stand, many active funds still represent nothing more than an expensive way to invest in equities (bonds are a different kettle of fish, and we'll look at that another day). Passive funds represent a cheap way.

You still have to decide whether you think equities are worth buying or not. But in terms of how you invest in them, then there's no contest unless there's a compelling reason to do otherwise, you should go cheap every time.