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Index Investors Win — At Least for Now

Index managers have won the debate over active and passive management, forcing the active crowd to up the ante on innovation.

I love the debate between investors who advocate for active management and those who ardently believe in passive funds. Even the names say so much. Active managers are eager to do battle with the markets, thinking they can outmaneuver and outthink their competition. Passive investors instead blithely take whatever the markets will give them; in return, they get the benefit of lower costs.

Bond investors too have bought the passive argument, even though indexed fixed-income funds have some serious flaws. For one, investors in fixed-income index funds end up buying the most debt from the most indebted companies. Not always wise.

But in many ways the debates about whether investors should buy into an active or passive approach don’t matter much anymore. Passive has won. Investors have decided that few portfolio managers can beat the market, and for years now they’ve been voting with their feet and switching from active managers to index providers. According to Morningstar, investors withdrew $63 billion from active U.S. equity funds in 2014 through September 30. During the same period they plowed $131 billion into indexed U.S. equity funds. Even actively managed taxable bond funds surrendered $2 billion for the year, while investors sent passive versions $58 billion in new money.

Traditional active equity managers are in trouble. Investors may ultimately lose a lot of good choices currently available in the market. But many active managers are trying some innovative ideas to save their business models. The surge in new smart beta funds, which use some kind of quantitative method to invest, is one sign of this creativity. With smart beta, active managers can offer investors a certain level of predictability and transparency while still actively trying to outperform the markets, or at least other index funds.

I recently spoke to Robert Shiller, Sterling Professor of Economics at Yale University, and Jeffrey Sherman, a portfolio manager at DoubleLine, about the DoubleLine Shiller Enhanced CAPE fund. The fund tracks an index that reflects Shiller’s cyclically adjusted price-earnings (CAPE) ratio. Especially interesting is Shiller’s idea of reframing concepts from behavioral finance in quantitative form — taking the portfolio manager’s emotions out of the equation. With the third edition of Shiller’s book Irrational Exuberance coming out early next year, it’s a reminder of the potentially disastrous consequences of following the crowd.

Recognizing that index funds’ popularity is partially a reaction to fees, active fund managers are also taking investors’ concerns about funds’ high price tags seriously. Eaton Vance Corp. is launching NextShares, which received approval from the Securities and Exchange Commission last week. NextShares allows managers to put actively managed strategies in an ETF wrapper. Eaton Vance’s concept will enable the firm to trim administrative and recordkeeping fees on its active strategies without cutting into the management fee itself.

Interestingly, Eaton Vance is also betting on the continued popularity of ETFs and will license its model to rivals. CEO Thomas Faust says that he’s still a big believer in active management but fees can be a big drag. Active managers need to think hard about fees and narrow the difference between active funds and index offerings.

Of course, as more and more investors index, who will set the fair value — or prices — of securities? Index investors just plow money into stocks or bonds based on their representation in the benchmark. Active investors are the ones who scoop up undervalued stocks and sell when securities reach their fair value. The authors of a white paper from fund manager Manning & Napier ask, “As money flows out of the active managers and into passive products, what impact is this going to have on the fair value setting mechanism in the market?” While it seems we’re still far from that tipping point, active managers may be able to shine if too many investors choose indexing. And that may be enough to push the pendulum back in the other direction.

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