By Sam Potter of Bloomberg
The decades-long debate over the virtues of active versus passive investing shifted abruptly in 2022. High inflation, rising interest rates and economic uncertainty disrupted equity markets, ending a long bull market and sending major indexes into a spin.
That reinvigorated the fortunes of stock pickers, who by some measures beat the market at the highest rate in almost two decades. It also slowed the $11 trillion march toward passive investing, a strategy in which an investor buys funds that hold all the stocks in an index like the S&P 500.
___STEADY_PAYWALL___Confusing matters further, the lines between these two camps keep blurring, as active investing gets more passive and passive gets more active. It all adds up to a chaotic new investment landscape in which the black-and-white, active-versus-passive choice of the past few decades is fading.
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1. What started the passive boom?
In and around the 1960s, a confluence of factors (in particular the advent of computers) allowed a small group of academics to show precisely how most money managers were performing versus the US stock market.
The conclusion was famously articulated by Burton Malkiel in his 1973 book, “A Random Walk Down Wall Street,” in which he argued that “a blindfolded monkey throwing darts at the stock listings” would do as well as the pros.
Trailblazers at firms including Wells Fargo & Co. and Vanguard Group Inc. developed index funds with the idea that by accepting “average” returns engineered by buying a broad swath of the market — but spending far less on fees — most investors would do better.
2. How did passive investing take hold?
Year after year the evidence against stock picking accumulated as the technology to automate buying and selling to match an index got better. Fewer than 15% of active US large-capitalization funds beat the market in the 2010s, according to data from S&P Global.
Fees for passive funds can be less than 0.1% of assets compared with more than 1% for the average active mutual fund. The dam finally broke over the last decade thanks to a combination of easier-to-trade products like exchange-traded funds (ETFs) and the mistrust of money managers sown by the 2008 financial crisis.
3. What are the implications?
By late 2019, passive strategies had swallowed up more than half of publicly traded assets in US equity funds. The share of passive strategies in areas like non-US stocks or bonds has yet to surpass that of active money, but the same trend is unfolding.
Index funds, used by both institutional and retail investors, are a big reason why more than half of all Americans are invested in the stock market today, a bigger share than in other rich countries. Companies such as BlackRock Inc., the world’s biggest asset manager, have also become the largest shareholders in many US corporations, leading to much hand-wringing about the potential dangers.
Concerns range from stock price volatility to the inefficient allocation of capital toward companies that have big weightings in an index. Another worry is that index approaches could delay a shift to so-called ethical investing if investment managers neglect their traditional role as company watchdogs.
4. How has active investing bounced back?
Active managers have always mounted a spirited defence of their craft, arguing that the period after 2008 was an abnormal one, with many stocks moving in lockstep rather than trading on their individual profit prospects.
Bad-mouthing indexing as “a blob,” they predicted that when markets got more choppy and stock performance became more dispersed, active investing would shine — and that’s what has happened.
While measuring the relative performance of fund managers is tricky, an analysis by Strategas Securities, an advisory firm, showed that 62% of active large-company “core” funds — those that buy a mix of growth and value stocks — beat the market in 2022. That’s the highest percentage since 2005. The question is whether it’s a blip or a sustained trend — and either way, whether it’s enough to save active management.
5. What’s next?
Active managers say passive distortions will create more opportunities for those who can spot bargains and avoid overpriced securities. Meanwhile, hybrid styles are emerging that mix the two.
Widely followed managers like Cathie Wood at Ark Investment Management are popularizing the use of active strategies inside ETFs. These capture the tax and trading benefits of an ETF but give managers more discretion.
Fees are slightly higher, and so far performance has varied widely. Since Wood’s market-beating success in 2020, such funds have launched at more than double the rate of passive vehicles in 2021.
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6. How passive is passive investing?
The field has evolved from buying the whole market to buying ever-smaller or more complicated slices of it and using a mixture of strategies to the point where many investors have what amounts to actively managed portfolios via a selection of index funds.
As more cash has shifted to indexing and ETFs, the number of gauges and funds has exploded, with about 3 million indexes and about 10,000 ETFs now in existence. Meanwhile, big money managers are racing to develop so-called custom indexing — another hybrid approach that’s arguably more active than the name suggests.
