Every year, it seems, there is a new argument against passive investing. Initially, it was considered ridiculous that any investor would accept the ‘average return’ of tracking an index. However, as research proved that in fact, most active managers underperform a broad market benchmark, the criticisms have grown more sophisticated.
Passive investing’s sins supposedly include distorting markets, increasing liquidity risk, and undermining price discovery. Some suggest that it is a bubble.
Most of these criticisms emanate from concerned active managers. What they are most concerned about, however, is up for debate. Are they worried about the rate at which they are losing market share to index products, or are they genuinely anxious about market integrity and investor outcomes?
Whatever the case, this active-versus-passive debate has eaten up a lot of time and energy in the industry.
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Under objective inspection, however, the desire on the part of many active managers to vilify passive investing seems bizarre. This is because, in reality, the rise of indexation is really in their best interests.
Or, more accurately, it is in the best interests of good active managers.
There are three simple reasons for this.
1. Cutting out the dead wood
One of the principles of competition is the concept of survival of the fittest. The most efficient, most productive and most innovative companies in any sector do well, and those that can’t keep up are either bought out or have to shut down.
This is one of the most celebrated features of capitalism, because it results in better outcomes for everybody: consumers get better products, workers can earn higher salaries as their companies become more profitable, and the economy is more productive.
Active asset management, however, has not entirely followed this path. There is competition, of course, but this has not been entirely based on the ability to deliver better outcomes for clients, in more efficient and innovative ways.
Mostly, it has been about who can distribute their products most effectively, regardless of their quality.
This is why active asset management has a poor reputation for charging high fees, not meeting client needs and making things unnecessarily complex. When the focus of your business is on selling products rather than delivering products that people want to buy, inevitably you will suffer this kind of criticism.
Active managers have gotten away with this for so long because, for a long time, there was no alternative. Investors had to go along with what they were being sold. The rise of passive investing, however, has put an end to that.
For active managers who really add no value, this is of course bad news. They are right to be alarmed.
For those who actually do a good job, however, it is finally an opportunity to properly differentiate themselves based on what they are actually doing, not just how effectively they can sell it.
As Alex Matturri, CEO of S&P Dow Jones Indices, explains:
“It’s like the culling of a herd. The first to get taken out are the weakest, and then you get left with better and better animals.
“The first active managers to lose their assets will be the worst managers. The better managers will survive and at some point they will show that they can add value.”
2. Educating investors
Linked to this is that one of the greatest achievements of passive investing is how it has increased the awareness of investors about what they should be looking for. Questions around fees and outcomes in particular have become far more prevalent.
The best active managers should welcome this scrutiny.
They should want investors to be asking the sort of questions to which they can give good answers, and which will reveal that there is a whole section of the industry that isn’t actually doing much for its clients. The inevitable result of this is a better industry.
3. A changing opportunity set
Finally, active managers should be cheering the amount of money going into passive products because ultimately it will give them more chance to do what they are good at.
In highly efficient markets, it is extremely difficult for active managers to outperform. The more money that is indexed, however, the less efficient markets will become.
This means that the good active managers will have more opportunity to identify mispricings and benefit from them, delivering better outcomes for investors. That, in turn, should see more money shifting to those active managers who demonstrate the ability to do this consistently.
For these three reasons, active managers should really be seeing passive not as a threat, but an opportunity. In fact, it’s probably the greatest opportunity they are ever going to get.