The Correct Way To Look At Passive Funds

There is a thought-provoking chart making its way around the investment community that demonstrates the rise of passive investment vehicles over the last decade.

According to recent data, the amount of assets under management in index mutual funds and exchange-traded funds has risen to account for a 40% share of the total fund marketplace. That represents a 50% jump over the last decade and clearly demonstrates the steady trend of assets migrating out of active strategies.

The Correct Way to Look at Passive Funds

All the monthly and weekly fund flow data supports this chart as well. Firms like Vanguard, Blackrock, and Charles Schwab are gobbling up assets at the fastest clip in the history of the world. Vanguard alone now owns nearly 7% of the market cap in the S&P 500 Index as of the end of 2016. That’s a wild statistic when you think of the trillions of dollars at stake.

In my opinion, the move to passive investment vehicles is one of the best things investors can be doing with their money. They carry the lowest costs, are fully transparent, offer tremendous tax advantages, and come in numerous flavors. They give you the closest approximation of the market move without the drag of portfolio turnover and human interaction.

I think it’s also important to point out that just because investors are moving to ETFs doesn’t mean they are going to buy and hold them forever. There is a great deal of activity generated in selecting, sizing, and re-balancing these investment vehicles. Furthermore, the human element has just been moved downstream from the fund manager to the individual investor or advisor. The decision to shift holdings or asset allocation will be primarily driven by the analytical capabilities and emotional fortitude of those who are using these tools.

Some believe that active funds will eventually cease to exist altogether. If your only experience in the market is the last ten years, it’s hard to believe that active managers will survive. However, it’s worth pointing out that there are areas where investors still perceive big advantages in the expertise of active management. Particularly in fixed-income and alternative strategies. There is a reason they still proclaim investors like Bill Gross or Jeffrey Gundlach the “Bond King”.

The media likes to paint a stark distinction between active and passive management like it’s a black and white test. The reality is far more nuanced as passive vehicles are used by active participants in the global marketplace. The blending of these philosophies is where portfolio management takes place in the real world and I expect that to only expand in the years to come.