“Passive” Investing is NOT Passive

September 22nd, 2017 | posted in: Investing

by: Andrew Berg

In 1976, John Bogle established the first passive index fund (what is now the Vanguard 500 Index Fund). Decades later, the concept of “passive investing” and the utilization of index funds is dominating headlines and gaining momentum amongst investors more than ever before.  Mutual funds, exchange traded funds (“ETFs”), and exchange traded notes (“ETNs”) that track broad (or sometimes extremely narrow) indices have attracted assets at a record pace over the past few years.  See the following chart that compares net flows into actively managed mutual funds (“Equity Mutual Funds” on the chart) versus passively managed index ETFs (“Equity ETFs”) from January 2001 through June 2017.

Though the aggregate amount of assets in actively managed funds is still larger, there’s no question that the dramatic difference in net flows over the last 8+ years has been a game changer. And it should be noted that while there are thousands of equity index funds now in existence, more than half of the assets that have flowed into passive equity funds since 2008 have been into funds that track the S&P 500 Index.  Past performance may not be a reliable indicator of future return, but it’s a very good predictor of future popularity!

There are a number of drivers behind this seismic shift, a subject that is probably deserving of its own paper. But suffice it to say that poor relative performance by active domestic equity managers since the end of the financial crisis, the proliferation of new index vehicles that provide one-stop, low cost exposure to various capital market categories and investment strategies (again, both broad and narrow), and a global investment environment awash with cheap money that has successfully lifted all boats with little discernment for traditional fundamentals or future earnings growth prospects are both the key variables at play and intimately interconnected to one another.

There’s also plenty of material available for a separate paper on whether or not this trend towards “passive investing” and away from actively managed funds will eventually mean-revert or represents a true, long-term paradigm shift. So I won’t touch that topic here, either.

Instead what I’d like to focus on is the great irony that most headlines about “passive investing” and most investors who claim they prefer a “passive investing” approach are using the term “passive investing” wrong.

Click HERE to access the White Paper on this topic.