This Powerful Investment Trend is Still on The Rise

The shift from active to passive investment management may be one of this past decade’s most significant financial trends, according to a Bloomberg View article. That’s right: the change is up there in import with much more talked-about topics like record-low interest rates, and even the 2008 financial crisis.

As an investor with 25 years of experience in the industry, I think this observation frames what has indeed been a significant trend: rather than investing and trading singular funds, investors are increasingly favoring indexed funds which allow assets to slowly appreciate with limited maintenance.

Passive investment, though unassuming in practice, is a powerful idea. With it, investors can sit back, skip the fees, and earn the market average. This saves effort and guarantees they will be doing better than at least half of the money out there, instead of attempting to beat the market as active investors do.

As the Bloomberg article explains, active investors tend to lose more, with only 40 percent actually beating the indices they are measured against. Research shows that this especially true for active managers after fees are paid, and that individual investors tend to make bad decisions on their own.

As an alternative, investors are turning to ETFs (exchange traded funds) and index funds. Though modest in reward, these types of passive investment funds favor appreciation over time to betting over price fluctuations, and are thusly considered more reliable.

What’s happening?

Dissatisfied with the performance of active investment management following the financial crisis, more and more investors decided that passive investment was a safer and more worthy opportunity. Now, passive products account for $1.3 trillion of US investors’ assets, or just under one tenth of the country’s GDP. As passive investment swelled, fees were lowered. The lowered fees incentivized more investors to get involved.

This trend toward passivity is what another Bloomberg article calls a “Napster moment.” With the arrival of Napster and eventually iTunes, music industry revenue was cut in half in 15 years. The finance industry could be in for something similar — and make no mistake, the advancement of technology is part of the reason. Just as digital music files made records obsolete, the technology that allows for bundling of assets, tracking indexes, and trading large numbers quickly reduces the need for pure active management, which needs constant upkeep and is vulnerable to human folly.

Impending revenue shrinkage also mimics that of the music industry. When money moves from active to passive management and is subjected to lower fees, revenues are cut significantly for asset managers.

Since 2007, passive investments have bloomed significantly; since 2015 alone, about $250 billion has moved out of actively managed mutual funds to passively managed index funds and ETFs. If this trend continues, ETF analyst Eric Balchunas attests, the industry could be cut in half.

What’s next?

It’s easy to see why passive is so popular: once a lower cost is paid for better or equal return, why would anyone want to pay higher fees again?

Still, I’m not inclined to believe that this trend means the demise of (or even significant detriment to) active investment management. Though surging, passive investments still only make up a small share of total funds, and even passive funds require a certain amount of active management as investors choose what to allocate, how much, and to where. This type of investment, called “smart beta,” may very well become a new type of popular hybrid.

I suspect a tilt toward active management will always be favored, as investors (and humans generally) are inclined to chase profit and compete. It’s also likely that when markets become more volatile, active management will regain popularity. 
The best case scenario for active investors, it seems, would be to achieve stellar results in spite of this trend. Active investment, which requires ongoing analysis and calculated action, is a legitimate way to make profitable investment decisions. But if it can’t prove successful in today’s market, passivity will continue to overtake it for better or for worse.

This post was originally published on StevenSands.net