Historically, our investment decisions have been entrusted to a stock picker or active investment manager. For several decades, active management has been losing ground to the passive investing approach – funds which invest in an index to cover an entire market. Not only does this approach offer diversification, the rise of passive has opened up markets that were previously unreachable. There are now indexed funds or ETFs for every type of asset.
The advantages of passive investing are cost and performance. It is typically much cheaper to track an index than it is to employ portfolio managers with the skills to outperform, or potentially outperform. Analysis of reports in major markets that compare the performance of active investors to passive indices show in the majority of markets, most of the time, indices can offer top quartile or better performance, not just the market average. An S&P study in 2016 showed that about 90 percent of active stock managers failed to beat their index targets over the previous one-year, five-year and 10-year periods.
Flexibility and transparency are also factors driving the change.
However, on the other side of the equation, there has been significant quantitative easing from central banks over the past 10 years which has caused equities to all rise at the same time. This high stock correlation means that it has been a difficult environment for active managers and generally, across most developed equity markets, active managers have underperformed their benchmarks.
Trading is not the primary driver of the growth in passive investing; instead, ETFs have been adopted as building blocks for mixed asset investors. ETFs have opened up a new investment landscape to many investors. They have lowered the barrier to entry to many assets and they’ve made unattainable assets available to some investors – or at least available in a diversified format.
While the poor performance of some active managers and some markets has contributed to ETF growth, it’s the key product features of being flexible, being transparent and being very cost effective that’s really driven the growth in Europe and the US.