Over the past few decades, there has been a substantial shift from active to passive investment strategies. This shift has occurred as investors have become more aware of the persistent failure of active management, as demonstrated in the S&P Dow Jones biannual Indices Versus Active (SPIVA) reports.
A January 2019 Federal Reserve Bank of Boston study, “The Shift from Active to Passive Investing: Potential Risks to Financial Stability?”, found that “Passive funds made up 45% of the assets under management (AUM) in equity funds and 26% for bond funds at the end of 2017, whereas both shares were less than 5% in 2005.”
Wall Street has been attacking and ridiculing passive investing for decades. Among the arguments are that the rise of passive investing results in a reduction in price discovery efforts, leading to prices being distorted and capital allocated inefficiently. This occurs because indexing either has too large an influence on prices or it inhibits price discovery because it lowers aggregate market trading volume.
The great irony is that if indexing’s popularity were distorting prices, active managers should be cheering, not ranting against its use, as it would provide them easy pickings, allowing them to outperform. (Note that if money flowing into passive funds distorts prices, it could still make it difficult for active managers while it is occurring, as distortions could persist as long as the flow continued. Eventually, though, the opportunity would manifest itself.) In reality, the rise of indexing has coincided with a dramatic fall in the percentage of active managers outperforming on a risk-adjusted basis.
As evidence of the declining ability of active management to deliver alpha, the study “Conviction in Equity Investing” by Mike Sebastian and Sudhakar Attaluri, which appeared in the Summer 2014 issue of The Journal of Portfolio Management, found that the percentage of skilled managers was about 20% in 1993. By 2011, it had fallen to just 1.6%.
This closely matches the result of the 2010 paper “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” The authors, Eugene Fama and Kenneth French, found that only managers in the 98th and 99th percentiles showed evidence of statistically significant skill. On an after-tax basis, that 2% would be even lower.
Vanguard’s research team contributed to the debate on the negative impact of passive investing on the price discovery function with its March 2019 study “A Drop in the Bucket: Indexing’s Share of U.S. Trading Activity.” To test the impact of indexing on price discovery, Vanguard measured not only turnover but cash-flow-induced trading.
Following is a summary of its findings:
- Despite the rise of indexing, total trading volume has been trending up.
- Since most indexing strategies have low turnover and trade at the margins of a large list of securities, their impact on trading activity and price discovery is minimal.
- Their base case yielded an estimate of approximately just 1% of all trading activity done by indexing strategies. Even under extreme assumptions, their estimates remained below 5%.
- Price discovery is driven by active market participants such as high-frequency traders (which account for about 50% of trading), hedge funds and individual investors.
You lose credibility when you try to claim that the segment of the market that accounts for between 1% and 5% of all trading activity is causing a distortion of market prices. Yet we hear this all the time.
One example of this type of criticism was an article titled “What No One Told You About Passive Investing.” Produced by Morgan Stanley, the thrust of the paper was that the “exodus from active to passive funds may be reaching bubble-like proportions, driven by an exaggerated critique of active management.”
It’s also hard to make the case that the price discovery function has been impaired (implying that securities are mispriced) when trading volume has been rising and the percentage of active managers outperforming has been on a steep decline for the past 20 years. Yet we hear this all the time as well.
Don’t be fooled by such criticisms. They all come from people and firms who don’t have your interests at heart. That is why they are not fiduciaries and fight to prevent being required to act solely in your interests.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.