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Worth Considering: Has the shift to passive index investing been overstated?

wc_peartreeInvestors are shifting away from actively managed funds and towards passively managed funds. The financial media have interpreted this as a “seismic” shift from active to passive investing, but they probably overstate, or perhaps they misunderstand, what is occurring.

Lost in the discussion is a crucial distinction between using passive funds and using a passive investment strategy. Investors are indeed increasingly favoring passive funds, but they are not necessarily adopting passive investment strategies. It is an important distinction.

First, let’s be clear about the distinction between active and passive funds. Actively managed funds have two defining characteristics: they engage in stock picking and they tend also to engage in tactical management. Stock picking in this context is a loose reference to individual security selection, whether stocks, bonds or another asset class. Managers of active funds screen the opportunity set and select the “best” securities in an attempt to generate market-beating performance. They may also make tactical adjustments to their holdings in response to changing conditions in the markets, the economy or world events.

Passive funds do not engage in stock picking nor do they make tactical adjustments. They simply aim to mimic the performance of a market benchmark, such as the S&P 500 for U.S. stocks, but at a much lower cost than active funds. Passive funds can be either a mutual fund or an exchange-traded fund (ETF) but nearly all the recent growth in passive vehicles has been through ETFs, so the expansion of ETFs is a reasonable proxy for the growth of passive funds.

Investors have been shifting away from actively managed mutual funds and into market tracking index mutual funds and ETFs for at least 20 years. Since 2007, the shift has been more pronounced and decisive. Passively managed funds, mostly ETFs, have experienced massive net inflows every year since 2007 pulling in nearly $1 trillion of new money. Over the same period, actively managed mutual funds have seen net outflows in nine out of 10 years losing just under $1 trillion. And the trend seems to be accelerating. In 2016, passive funds saw net inflows of nearly $250 billion while active funds experienced net outflows of about the same amount.

On its face, this is a seismic shift and several factors are likely at work. First, the underperformance of active fund managers as a group has been the widely acknowledged. In the latest report from S&P Dow Jones Indices, over 90% of U.S. large-cap and small-cap managers underperformed their benchmarks over a 15-year period. Investors and financial advisers have started to notice.

A second factor has been the widespread adoption by retirement plans of target-date funds comprised of index funds. Target-date funds are the most commonly used investment choice in most 401k and other group retirement plans. As plan sponsors, employers have a fiduciary duty under federal law to act in the best interests of their plan participants; many employers have seen fit to discharge this duty by using index funds, which generally offer much lower costs and on average offer better performance.

A third factor is the financial advisers who collectively control trillions of dollars in the U.S. markets. A survey of financial advisers released this year confirmed that since the financial crisis, advisers have steadily been shifting clients’ money away from conventional mutual funds and into exchange-traded funds. This is probably attributable to a combination of performance and cost.

Most advisers are aware of the reports by S&P Dow Jones over the past 15 years documenting the underperformance of most active managers against their market benchmarks. Advisers are also sensing increased pressures to reduce total investment costs for their clients and one easy way to do so is to drop the more expensive, actively managed funds charging nearly 1% annually on average to passively managed index funds charging .1% or less.

Notwithstanding the clear trend away from actively managed funds and towards passively managed funds, not all of it represents an increased adoption of a passive investment strategy. A passive investment strategy is one that holds a market-like allocation with a strategic—that is, long-term—mindset rather than a tactical mindset. Much of the shift in passive funds—how much is difficult to quantify—simply reflects a new way for investors to build actively managed portfolios. We know this inferentially.

First, the Vanguard Group, perhaps the largest provider of passive index funds, analyzed the allocation of passively managed funds relative to the broad market. They reasoned that if more investors were truly using index funds to track and capture market performance then, in the case of U.S. stocks, the flow of money into U.S. stock index funds would look like the allocation of the broad U.S. stock market. It does not.

Since 2002, the allocation of U.S. stock index funds has underperformed the performance of the total market index by as much as 8%. That means that many index fund investors are over-allocating to some market sectors and under-allocating to others, effectively making active, tactical bets against the broad market. On average, this has been a losing bet that has underperformed against the market.

Financial author Michael Kitces has noted that although financial advisors are using more index funds than ever before, they still hold the overwhelming share of their clients’ money in conventional mutual funds. A recent survey by the Financial Planning Association revealed that the percentage of advisors exclusively following a passive investment style decreased from 25% to 15% over the past three years even as the adoption of ETFs has been on the rise.

Kitces believes that advisors are sprinkling low cost ETFs into their otherwise actively managed portfolios largely to bring costs down and not because more of them are adopting a passive, index based investment strategy. A Barron’s columnist shares this cynical view, suggesting that “the sticker shock of paying an advisor 1% every year plus another 1% or more for an actively managed mutual fund is too great for most investors to bear—so the advisor dumps them into an index fund.”

While difficult to quantify, it appears that many advisors are simply using passive funds, especially ETFs, as another way to build actively managed, tactically allocated portfolios. The supposed trend of more advisors adopting a passive investment style is a “mirage,” according to Kitces.

If so, what are the implications for investors? One is that many investors, including financial advisers, may be missing the point. Index funds were designed to capture market like performance at a low cost. Over time they have demonstrated their ability, if properly used, to outperform the overwhelming majority of actively managed funds. You should remain skeptical that they can be tactically managed in a portfolio to produce market-beating returns.

Second, investors and their advisers need to be clear and consistent about the investment philosophy they intend to follow. Don’t be fooled into thinking that the tactical trading of passive vehicles like ETFs is anything other than a different take on active management.

David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625, [email protected].