The book The Tipping Point by Malcolm Gladwell has the sub-title ‘how little things can make a big difference’ and this is perhaps how the looming fact of parity – and beyond – for passive assets with active should be viewed.
In itself, parity will mean little given the already substantial momentum behind passive, and within that ETFs. But the very fact passives are now on the cusp of overtaking active assets does pose some questions for the global markets as a whole.
The difference of opinion over when exactly passive assets under management (AUM) will first achieve parity with active, and then presumably outstrip it, comes from two pieces of analysis produced this year.
The first was from Moody’s Investor Research in March which suggested that in the US by 2021 passive assets, which totalled circa $5.7trn at the end of 2018, would overtake active where circa $7trn of investor cash was parked.
“Adoption of passive investment products in the US continues unabated,” the Moody’s analysts wrote at the time. “Lower-cost passive investment products more efficiently channel the earnings of corporate America to the end investor than do traditional mutual funds.”
The more conservative estimate from PwC is based on predicting what might happen to both passive and active AUM in any future downturn. Yet it only pushes back parity by four years and adds that by that date total assets in mutual funds – which includes ETFs – will hit a whopping $26.8trn.
Parking the difference in quantum for a short while, it seems worthwhile to ask whether the very fact of parity being reached – and then presumably seeing passive outstrip active – has anything other than a symbolic resonance.
As Oliver Smith, portfolio manager at IG Portfolios, says the 50/50 mark will have symbolic value “but investing will not get any easier”.
“Only the best active managers will be able to consistently outperform their benchmarks over consecutive market cycles.”
Peter Sleep, senior portfolio manager at 7IM, similarly says the tipping point, while significant for the sales managers of passive funds, only applies in equities.
“[There is] still a long way to go in the fixed-income market (towards 50%), which is a similar size to the equity market,” he says.
More pertinently, Sleep also suggests that a “sense of perspective” needs to be adopted when it comes to any active/passive debate.
“One of the purposes of financial markets is to act as a conduit to channel surplus cash from mature areas of the economy to new areas of the economy to fund the growth and employment of tomorrow,” he says.
Passive, he point out, “does not do this”. Sleep argues: “It takes surplus cash from mature areas of the economy and puts it right back into mature areas of the economy. If all capital is channelled this way job creation and growth will quickly die.”
This is the point that, in ETF circles, made Alliance Bernstein’s Inigo Fraser Jenkins famous when he declared that ETFs were “worse than Marxism”.
Yet as Mark Northway from Sparrows Capital suggests, the point that ‘peak passive’ is reached – at whatever percentage that might be – ill mean that a “sufficiently large” opportunity will have opened up for active funds – or price makers – to generate attractive returns.
“At that point capital will logically cease to reallocate toward passive but will instead be reallocated to active management and liquidity provision, resulting in a state of natural equilibrium,” he says.
“The problem is that as with most market forces there is absolutely no way of predicting where that equilibrium point will occur until it has already happened.”
This gets to the heart of the debate about whether indexing, broadly, would increase volatility in a time of market stress.
“The suggestion is that in a market comprised primarily of price takers there is less tendency for prices to correct as new information reaches the market, and that this in some way results in higher stock price correlations and in single-stock price inefficiencies,” says Northway.
“This claim completely ignores the corollary argument that price makers are the beneficiaries if such inefficiencies arise and the effect of resulting actions by price makers are magnified in such a situation.”
As Sleep says, one of the purposes of active management is to assess all the investment opportunities available in the market and “assist the efficient allocation of the world’s limited resources”.
“Passive management is blind in that it allocates capital without any criteria other than market cap,” he adds.
However, it is the degree to which active management has failed to achieve this allocation that perhaps helps explain why passive has risen so quickly. Here the issue of high fees for less than stellar performance enters the equation.
“Historically, the asset management industry has failed to do this efficiently, with the industry underperforming largely due to its high fees,” says Sleep. “Passive investors still underperform but they underperform the market by a great deal less and in a more predictable manner.”
As to whether passive investors – and those invested in ETFs in particular – might somehow pose a systemic risk whenever the market next hits a significant downturn, Northway is sceptical.
“There has also been much concern raised about an ETF bubble and the potential impact of a herd-like rush for the exit,” he says.
“Such a risk might indeed exist if the overall flows into the equity markets were significantly higher than historic levels; but a review of historical inflows suggests that what we are experiencing in the ETF market is a shift from active to passive rather than a net increase in new money.”
The somewhat nervously poised nature of the market today is engendering speculation as to what might spark another crash.
“Yes, equity market feel expensive; yes, there will be a rush for the door at some point; and yes, the finger of blame will inevitably be pointed at ETFs,” says Northway. “But in practice any price fall will simply be a reflection of capital flight from the overall equity markets.”
He adds that the ETF share creation/redemption mechanism should limit the size of any intraday relative price movements and, indeed, that the use of ETFs as a “risk-management instrument” might be seen as vindication of the important role they now play in the global capital markets.
Smith concludes by suggesting that while the question of when the tipping point might occur is “conceptually interesting”, it is yet to be tested. “50/50 parity will mark a milestone in the growth of passive strategies, but investing will not get any easier – only the best active managers will be able to consistently outperform their benchmarks over consecutive market cycles,” he says.
Similar comments come from James McManus at Nutmeg. “I think as you say this seems to be an inevitable trend, so there will be little surprise when we get there,” he says.
“Clearly active managers have room to cut management fees but this is easier said than done. However, fees alone will not solve this issue – it is also the consistent and chronic underperformance of active managers after fees and a greater focus on asset allocation over stock picking that has driven investors to passive strategies.”
But he cautions “a lot can change” between now and when parity occurs, whenever that might be.
“The performance of the active industry in the next significant, prolonged down turn will be critically important.”
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