Structural implications of the active vs. passive debate
The surge in assets devoted to passive investing since the financial crisis has been partly driven by an explosion in the number and breadth of index-based products available to investors. Gone are the days when investing in a passive fund meant just buying the SPY and going back to sleep.
Now, the speed and spread of information, aided by tremendous computing power available at very low cost, means the indices against which passive investment funds benchmark themselves have become increasingly specialized, and there are now more index funds and ETFs than listed corporate equity securities. This raises a host of questions.
At first glance, one might think the greater the choices, the greater the competition and thus pressure on fees. To some extent, this is happening, especially among the more commoditized flavors of broad equity and bond market proxy funds. But the trend towards more passive vehicles than listed stocks begs the question of whether returns will coalesce around the lowest common denominator when everyone congregates into an ever-shrinking pool of instruments. The answer? Probably, and while fees will be in the cellar, so will return dispersion. Such a scenario is a long way off, however, according to BlackRock’s Kate Bernhardt during a panel on passive investing as part of Bloomberg’s inaugural Buy-Side Week 2017 New York event. “Of the $26 trillion U.S. equity market, the proportion of single stocks or single bonds held in an ETF wrapper last year was around 7%. For mutual funds, that number is 36%. For the $48 trillion bond market, the comparable figure is less than 1%. It’s pennies on the dollar. If you’re characterizing the trends in flows today as all active into passive, you’re missing a lot of the nuances.”
Another structural topic increasingly debated is the fear that ETFs will have a negative effect on liquidity. But that’s a very 2011/12 way of viewing it, noted Krishna Memani, Chief Investment Officer at OppenheimerFunds.
“If you are a bond manager, you know liquidity has always been suspect. Like-minded movers can dominate the market, and outside players don’t take the other side in a particular issue. But when you aggregate it all and provide a separate vehicle, speculators can come in and take the other side of a trade. ETFs have categorically added liquidity to markets, not the other way around.”
“Structurally, the majority of ETF assets are in ‘40 Act funds, which means they are essentially mutual funds with two exceptions: they can trade with each other, and they provide intraday NAV’s instead of end-of-day ones,” added Jim Rowley, Senior Investment Strategist at Vanguard. Both provide levels of trading that would otherwise not be possible.
However, consider that ETFs accounted for approximately 30% of U.S. trading by value and 23% by volume last year, seven out of the top ten issues by volume in 2016 were ETFs, and overall ETF trading volume grew 17% last year after jumping a whopping 50% in 2015, according to Credit Suisse. By comparison, U.S. stock trading volume has grown an anemic 7% since 2014.
The concern is that the high proportion of ETF volume masks an inherent liquidity trap when it comes to the underlying assets such funds represent. It’s not the volume of ETF trading itself that matters, but how that volume is ultimately translated to each index’s constituents – especially if everyone heads to the exits at the same time.
Finally, an element often missing from the active versus passive debate is what happens to corporate governance as passive market share grows. When index funds and ETFs own most of a company’s stock, does management still have its feet to the fire? Vanguard’s Rowley pointed to his company’s active governance team and others like it as a reassurance, but OppenheimerFunds’s Memani isn’t so sure. “The markets are much better vehicles for enforcing such discipline,” he said. In other words, a few emails to management from a passive fund’s governance desk is not going to replace Bill Ackman or Carl Icahn showing up at a company’s annual meeting with a shareholder value plan and slate of director nominees. “For this reason, I don’t think the trend towards indexing gets to 70-80%,” Memani added. “We need intermediaries in the marketplace.”
Finally, delving into the active versus passive debate also raises the question of whether at least a portion of today’s indices are merely replicating what used to be an active approach. “Screening for fundamentals and using quantitative, tech-based tools to build a portfolio is what active managers have been doing behind the scenes for years, whether in a separately managed account, a mutual fund, what have you,” noted Bernhardt. “A rules-based index that screens for specific fundamental criteria, for instance, and is then accessed through a cost-efficient, tax-advantaged, transparent vehicle like an ETF is redefining active, not replacing it.”
