The writer is chief investment officer at Man Numeric
It has become conventional wisdom in markets that the continued rise of passive investing is seemingly inevitable.
If active investors charge fees and pay transaction costs, they will on average underperform a passive benchmark. Over time, this return advantage has become so obvious that the dominant force in the US equity market today is passive.
But while the core tenets of passive make sense, past performance is no guarantee of future results. Passive strategies have disproportionately benefited from the wave of money that has moved from active to passive.
Estimates of passive market share in the US range from 25-50 per cent, and our internal analysis agrees. But we think this underestimates the impact of passive.
Many equity managers offer strategies that are active but hug their respective benchmark to some degree. Looking at regulatory filings by institutional fund managers of their holdings, we estimate the asset-weighted active share across the Russell 1000 has fallen to 35 per cent, including a material drop over the past five years.
Simply put, this suggests that only one out of every three dollars (held by institutions) deviates from a cap-weighted benchmark; so the US market may actually be two-thirds passive.
We are not suggesting that this will (or should) reverse, but we do believe there is an increased opportunity in active. Let us start with the two clearest benefits of passive investing: very low fees and transaction costs.
Passive fees have always been very low on a relative basis, and over the past decade have fallen to near-zero for virtually everyone. This competition has driven active fees down (and will probably continue to do so).
Additionally, as liquidity has improved, transaction costs have declined, so the cost of active turnover is less than it once was. While passive investing still enjoys an advantage, it is meaningfully smaller than it was two or three decades ago.
There is another advantage that passive had over the past few decades that is unlikely to be replayed over the next decade or two: the trillions of dollars that migrated from active to passive strategies.
Morningstar estimates that in 2022, active US equity mutual funds had net outflows of $926bn, while passive funds had net inflows of $556bn. This would indicate that on a typical trading day, there was a net flow advantage of nearly $6bn for passive funds (using similar Morningstar data, that number was approximately $2bn in 2021).
While it is hard to quantify precisely what kind of net benefit that lends passive over active, our estimates are up to 2 percentage points annually. Whatever the advantage has been, with the market effectively two-thirds passive, history is unlikely to repeat itself.
We also believe investors should take into account cyclicality. This appears to be a feature of many types of investment strategies; good performance leads to positive flows, which further aids performance. But this eventually leads to too many assets in a particular strategy, which finally leads to underperformance.
Passive investing is still not at any kind of theoretical limit, but when you include the impact of active investment strategies’ benchmark hugging, we believe it may be approaching an upper limit. Increasingly, the marginal dollar invested in the market is simply buying the market. If certain equities become irrationally overvalued, passive funds are increasingly allocated towards it.
The relative performance of active managers in particular appears to exhibit cyclicality, and they have gone through roughly a decade of difficult performance.
Passive disproportionately benefited from the continual bouts of quantitative easing and historic levels of fiscal stimulus, where the best strategy was simply to own the market and buy the dips. A different environment may call for more discretion and less complacency among equity investors.
While active managers struggled relative to passive benchmarks in the late 1990s, active rebounded quite significantly over the next decade. Following a decade of recent underperformance, active managers appeared to stage a rebound in 2022. Was 2022 an anomaly, or the start of a new cycle?
Passive has been a boon for the typical investor at the expense of active management, and rightly so. But as we approach peak passive, the playing field looks a lot more level going forward.