Imagine asking people on the street what comes to their mind if they think about investing. It is highly probable that the lion’s share of the sample will think of stocks, or maybe bonds. Some might even express the term fund. I’d take a huge bet that almost nobody would say “ETF” as its first guess.
Actively losing the Pole Position
It is safe to say that passive investments, e.g., in forms of ETFs, fly under the radar of many investors; especially in European countries. Yet, the era of fund managers picking stocks to increase private savors’ wealth is slowly ending. In September 2019, passive equity funds outstripped their active siblings, heralding the start of a new status quo. Right now, investors allocate more capital in passive equity ETFs than in active equity funds, and the end is nowhere in sight.
As hinted, passive equity funds do not depend on individual human decisions, dealing with which stock to buy and which one to sell. They follow pre-defined and transparent rules, which constellate a basket of securities, better known under their alter egos: indices. Passive investment vehicles, e.g., ETFs, are simply tracking those indices. No wonder that the term „index fund“ is often used as a synonym to an ETF.
Passively driving at the Racing Line
Why are index funds or ETFs so successful? One of their fundamental advantages is their lower costs. Since index funds do not require a fund manager to make decisions, costs in passive investment can be significantly lower than in active asset management. Additionally, active managers charge performance fees from their clients as a reward in case they performed better than the pure market. These benchmarks themselves are nothing else than indices showing what investors would have earned if they just invested in an index tracking the market development. In the short run, active managers might indeed be able to generate an outperformance (alpha) compared to the pure market (beta).
Litting the Tires
In many cases, the alpha is scooped through market inefficiencies and information asymmetries, rendering the dogma of “no free lunch” completely useless. In the long run, however, it is no safe bet that a fund manager will always be able to beat the market on a scale that it would justify charging high fees. In many cases, the Total Expense Ratio (the total fees for funds) of active asset managers turns out to be so high that it leaves less net performance than if one would’ve just invested in the underlying benchmark. Even if the fund manager scores some alpha, the active manager’s performance fees may scorch the outperformance entirely.
What’s under the Hood?
Additionally, index funds are incomparably transparent. Their index constituents are visible for anyone with a working internet connection, and the fundamental calculation strategy is open for everyone to read and, therefore, to replicate. Within the active management sphere, managers never give away their secrets, making their trades in a black box, not giving much insight into their investment rationale.
The success story of passive investment is also a success story of its creators and underlying strategists: Index providers. If more assets are managed passively tracking index providers’ indices, the question arises who is the real fund manager now? Especially since not all index strategies are plain-vanilla market trackers, but sophisticated quantitative or thematic approaches (minimizing risk or giving exposure to certain industries), passive asset management can generate outperformance by breaking into active territory while maintaining competitive pricing. Index providers like Solactive are now at the forefront of this trend, which is expected to endure. The growing acceptance for investing within retail customers, which, in some cases, earn negative returns in their saving accounts will drive the demand for passive strategies even more. The fuel running this new engine of global wealth is the players providing and developing the indices.
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