Why the shift to passive investing?

Why the shift to passive investing?

When looking at what is driving the shift towards passive investing, I’d first of all like to say I prefer to call it ‘index investing’, as the former term implies the investor is ‘lifeless’ or ‘inactive’. 

The move to indexing is being driven by several factors, including investors increasingly embracing the benefits of being diversified within and across asset classes. It is also fuelled by the recognition it is difficult to pick stocks or bonds that perform better than the benchmark.

On top of this, it is hard to find active funds that consistently beat their benchmarks, while the costs associated with stock-picking also play a role.

It is also the case that more investors are developing financial plans based on when and how much money they will need.

Once you have decided on your asset allocation, which forms the building blocks of your portfolio, you look at which investments will best fulfil those allocations. Many money managers prefer to pick individual stocks and bonds in their home country or region but use ETFs, funds or derivative products to invest in markets where they lack expertise, access to research or the ability to invest directly.  

Let us assume that one of the target allocations the investor wants to implement is exposure to the US  stock market, as represented by the S&P 500 index. Performance is one of the key considerations for investors and most would like to find active funds that consistently deliver returns that are above the index – the S&P 500 in this example. But finding funds or a fund that consistently delivers on this goal is a significant challenge for both retail and institutional investors. 

In his often-referenced article, ‘The Loser's Game,’ published in the Financial Analysts Journal, Charles Ellis highlighted the shortfall of active managers. He noted that over the prior decade, 85% of all institutional investors who tried to beat the stock market underperformed the S&P 500 Index.

The challenge of finding professional managers who consistently beat their benchmark – as measured by the S&P 500 index - and delivered alpha by picking individual stocks has not changed much in the past nearly forty years.  

Numerous studies have shown that it is hard for professional active investors to consistently beat their benchmark. What’s more, the annual costs associated with investing in active funds is significantly more than investing in an index fund designed to track the same benchmark.

These higher costs are another important factor accelerating the move to index investing. Since the recent financial crisis, investors have become more aware of the impact these expenses can have on active fund performance. An active fund that delivers returns below the benchmark prior to costs being deducted looks like a faulty choice for a building block after deducting the typical annual 1.50% expenses for active funds.  

An index fund may not offer the potential to outperform a benchmark, but you do know you will get the benchmark minus fees and any tracking error, which should be very small - typically less than 0.50 percentage points for an S&P 500 index fund. 

Over the past few years we have seen growth in the use of index investing by both retail and institutional investors through futures, structured products, equity-linked notes, index funds and ETFs.

Investors need to be diligent in determining how they might implement index exposure to their selected benchmark. Futures tend to cover less than 80 benchmarks. Also, many investors aren’t allowed to use futures, while others are limited in their use and others prefer not to use them. 

Structured products and equity-linked notes are investment vehicles, which are created by banks and brokers on a bespoke basis. They typically require an initial investment of $20 million to $100 million, depending on the index.  

Meanwhile, index mutual funds tend to exist only on well-known indices while ETFs cover an ever-expanding array of indices and asset classes. ETFs offer a number of benefits over many of the other alternatives mentioned above: small minimum investment, typically less than $80; liquidity; diversification; low cost; exchange-traded; and real-time access to a wide range of indices and asset classes around the world.