On Passive Investing and the Rise of ETFs
Passive index investing has been replacing active management at a rapid clip. Given that most active managers seem to underperform the market, eliminating experts and paying lower fees may be a win for investors.
Bank of America Merrill Lynch recently estimated that assets in US-domiciled passive equity funds have doubled since 2008, making up roughly 40% of the market today. Since 2009, investors have sold a cumulative ~$200B in individual stocks and replaced them by buying ~$160B in ETFs.
Figure 1: Asset Split, Active vs Passive US-Domiciled Equity Funds (2009 – May 2017)
Source: BOAML, The ETF-ization of the S&P 500, 2 July 2017
If there has been a wave of money flowing into passive investing in the United States, then Japan appears to have been hit by a tsunami. About two thirds of investment in Japan is now passive.
Figure 2: Japan-Focused Equity Funds: % of AUM in Passive vs Active Funds
Source: BOAML
These passive flows do not affect every market segment equally. ETFs require liquid underlying names to function, and so the vast majority of indexed money has flowed to liquid large cap indices. A quick survey of the largest US ETFs has two giants linked to the S&P 500 leading the pack: the SPDR S&P 500 (SPY), with $237B in AUM, followed by the iShares Core S&P 500 (IVV), with $118B in AUM. The S&P 500 is a market cap–weighted index, so investors in these ETFs are putting roughly 12% of their money behind five of the biggest US companies: Apple (3.7%), Microsoft (2.6%), Amazon (1.9%), Facebook (1.8%) and Johnson & Johnson (1.7%). Investors following this “buy the biggest” strategy may be susceptible to crowded trades in the most visible names in the market.
Fashionable indexes like the S&P 500 largely ignore fundamentals, as the only “fundamental” that influences its stock allocation is “bigness.” Japan’s Nikkei 225’s index methodology arguably makes even less sense. The Nikkei is a price-weighted index, meaning that stocks with individually high share prices make up a greater weighting in the index. Hence, 7.05% of the index is a company called Fast Retailing Co., whose stock happens to trade for 35,000 yen per share, while Japan’s largest company, Toyota, makes up only about 1% of the index, with a share price of 6,000 yen.
In a passive environment, the question then becomes what rules should investors live by, rather than what stocks should they pick. Today investors have more options for investing styles than there are individual stocks in the market!
Figure 3: Individual Stock vs Indexes
Source: Bloomberg, “There Are Now More Indexes Than Stocks” 12 May 2017
We believe the opportunity for active management lies primarily away from the liquid, large cap names that are dominated by large and passive capital flows and toward the neglected small and less liquid segments of the market. Away from the crowd and the sloshing of central bank liquidity, we believe there is serious mispricing, especially in securities that are more complex due to leveraged balance sheets or that fall out of favor due to neglect or pessimism (e.g. value stocks). In such a passive environment, where a greater proportion of funds are often invested by rote rules rather than rigorous research, we sense greater not less opportunity for certain styles of active management. We believe in the future of niche, capacity constrained high alpha active management. But one has to be willing to go where the crowds aren’t.