There is little doubt that passive funds can have a valuable role to play in people’s portfolios – but there is a serious question mark over whether now is the right time to be buying passive investments
Here’s a fun fact – if assets under management were on a par with the size of a country’s gross domestic product, the world’s largest tracker fund would be the world’s 45th largest economy. The ‘SPDR’ exchange-traded fund (ETF) that tracks the S&P500, the main US equity market, is some $240bn (£186bn) in size, which on 2016 IMF figures puts it a little way behind Chile but just ahead of Finland.
Nor is that the only astonishing statistic about the SPDR ETF. As Gerard Minack of Minack Advisors points out in a recent piece of analysis entitled There is no Plan Beta, the portfolio turns over at a rate of 1.2 times every month. To put that another way, some $288bn flows into and out of the SPDR ETF every month, which means that, while it may be a passive investment, investors would appear to be using it in a pretty active way.
The question of just how active some passive offerings might be came up as part of a wider discussion by Minack on the relative performance of active and passive funds. For while the received wisdom is that, after fees are taken into account, active funds always underperform their benchmark, the reality is rather more nuanced.
Yes, that may be true in aggregate for the market as a whole but, as the following chart illustrates, sometimes a lot of active funds will outperform their benchmarks and sometimes a lot will underperform. As with much of investment, the chart also reveals a cyclical element to all this – as Minack observes, “the irony is that active managers often struggle in bull markets” and the cyclical lows shown below have typically preceded bear markets.
Percentage of funds (fund assets) outperforming S&P 500 on a 5-year basis
Source: CRSP, Bloomberg, Robert Shiller, Instinet research, Marketwatch; Minack Advisors
There is also a psychological element to investment and, given the degree to which active funds have been underperforming of late, it is not a huge leap to understand why so much money has been flowing towards passives. But of course, if that is so, it would be a classic case of people investing as they look in the rear-view mirror – that is, chasing short-term performance that is already in the past.
As the next chart – also courtesy of Minack Advisors – shows, it is an unfortunate fact of investment life that while active funds can have a hard time outperforming their own benchmark, on average they have no trouble outperforming their own investors. This is because, as Minack explains, investors tend to sell active funds after these funds have done poorly and buy them after they have made gains.
5 year average mutual fund returns
Source: CRSP, Bloomberg, Robert Shiller, Instinet research, Marketwatch; Minack Advisors. Past performance is not a guide to future performance and may not be repeated.
To return to where we came in, Minack suggests that performance gap is important because “it seems most of the money moving into passive investments is not passive money” – and indeed quite the reverse: “‘Passive’ investments are being aggressively traded.” “In short,” he concludes, “it seems very likely there will be a large gap between returns to investors in ‘passive’ funds and the returns on those funds.”
Here on The Value Perspective, as committed active fund managers ourselves, we will always try and make the case for good active fund management and yet of course we understand that passive funds can have a valuable role to play in people’s portfolios. That said – and being as objective as we possible can – we would seriously question whether now is the right time to be making the switch from active to passive.