The move toward passive funds, a recent trend in investing, has continued in 2017. According to research from Morningstar, retail investors pumped more than $500 billion into passive products last year alone, yanking $340 billion from active managers in the process. The bulk of this transition occurred in U.S. equity mutual funds. In fact, actively managed U.S. equity funds have not had a positive net inflow calendar year since 2005.
In hindsight the reason for this wholesale revolt by investors is apparent. Roughly 80 percent of active large-cap mutual funds trailed their benchmark last year, and the median active manager has trailed the market in six of the past seven years. On average, these active funds charge a 1.0 percent management fee. Compare this with the 0.25 percent charged for the typical passive product. Seems like a no-brainer.
Or is it? Though it’s true that active managers have underperformed over the past seven years, trailing the passive substitute by 1.1 percent per year, it’s also true that from 2000 to 2009, active managers beat their bogeys every year but one, averaging nearly 2.5 percent each year over the benchmark. For the five-year period before that, passive won. And for the five-year period before that, active won.
Clearly, there are strong cyclical arguments to be made in this debate, and one might propose that moving to passive now is the equivalent of buying at the top. This is certainly the suggestion active managers are making as they wait for their day in the sun to return.
Aside from these cyclical and behavioral reasons, there may also be some structural issues for investors to consider before making the switch.
Let’s spend a minute discussing market efficiency, because that’s what this debate is all about.
Market efficiency is generally described as the degree to which all publicly available information is already reflected in a security’s clearing price. In theory, the more efficient a given market is, the harder it is to outperform the simple strategy of holding a passive basket of all the securities in it.
One problem facing investors trying to determine the efficiency of a particular market is that market efficiency isn’t static. It changes over time, as market structure and participant supply-demand characteristics change.
Looking at the domestic stock market, things have changed dramatically over the past several decades. In 1996 there were approximately 9,000 publicly listed stocks in the U.S. Pursuing these opportunities were 8,000 mutual funds and 500 hedge funds. Fast-forward to 2017, and there are now just 4,000 publicly traded stocks to select from, and many more investors going after them. Using recent estimates from various sources, there are approximately 15,000 mutual funds, 2,500 exchange-traded funds, and nearly 10,000 hedge funds fighting for excess returns in a shrinking market.
Charles Ellis, founder of Greenwich Associates and a vocal advocate of indexing, has estimated that over the past 50 years, the number of investment professionals actively engaged in price discovery has risen, from about 5,000 to well over 1 million today. In effect, the needle is getting smaller while the haystack keeps getting bigger.
Another problem facing investors is that not all markets are equally efficient.
No institutional investor is indifferent to public equity or private equity, or stocks versus bonds. We make asset allocation decisions, and hire managers to invest in a given asset class, in a very well-defined, “stay in your box” way, for better or worse. If asset classes are stratified things, never to mix, then it stands to reason that market efficiency itself must be a stratified outcome.
Large-cap value stocks and U.S. Treasury bonds, for instance, are highly efficient markets no matter how you measure them. They have very low commissions, are highly liquid, and exhibit tight spreads between top and bottom managers. The top 25 percent of public equity mutual fund managers outperform the bottom quartile by just 2.5 percent per year.
Compare this with emerging-markets equities, where commissions and other transaction costs are higher, or even private equity. In private equity the top-quartile managers outperform the bottom quartile by a whopping 20 percent a year.
Which brings us to the ultimate paradox of market efficiency.
I once had a supremely confident hedge fund manager tell me without equivocation, “Chris, I am market efficiency.” Though his delivery was off-putting, in many ways he was right.
The more investors seek to exploit inefficiencies in a given market, the more efficient that market becomes as those opportunities are priced away. Conversely, the more investors are convinced of the infallibility of a market’s efficiency, the more inefficient that market becomes as fewer participants engage in active price discovery.
Investors would be well served to think long and hard about market efficiency versus their internal resources when determining to which asset classes they should — or shouldn’t — allocate active risk.
And about that, at least, there shouldn’t be any debate.