High profits of active managers are unlikely to survive the rise of passive funds
Robin Wigglesworth
The Big Short. The doctor-turned-money manager Michael Burry — one of the heroes of the film — recently caused a stir by arguing that index funds are a massive bubble © AP
Thanks to Hollywood, the protagonists of Michael Lewis’s The Big Short enjoy mainstream fame that most financiers can only dream of. But celebrity and clairvoyance are rarely positively correlated.
The iconoclastic doctor-turned-money manager Michael Burry — one of the heroes of The Big Short, portrayed by Christian Bale in the subsequent film — recently caused a stir by arguing that index funds are a massive bubble. He even likened them to the toxic collateralised debt instruments that he shorted ahead of the financial crisis.
The index fund universe has certainly ballooned, and now holds close to $10tn, according to the Investment Company Institute. That is still just a fraction of the global asset management industry, but is up fivefold since before the financial crisis.
The shift is particularly stark in the US, the birthplace of the index fund some 40 years ago. Morningstar estimates that as of last month passive funds in the US manage more money than the “active” stockpickers that have reigned since the advent of the mutual fund. An arbitrary milestone, but a notable one nonetheless.
Setting aside the fact that “bubble” is a grossly overused term, this could more accurately be described as the overdue deflation of an active management bubble, which has expanded for nearly a century despite reams of evidence that most money managers underperform the market after fees.
Last week S&P Global released the results of institutional fund manager performance for 2018, and it wasn’t meaningfully better than the results it has compiled for mutual funds aimed at retail investors. Even before fees have been deducted, almost 78 per cent of big equity mutual fund managers and 73 per cent of institutional accounts have underperformed the S&P 500 over the past decade. To varying degrees, the same is true of other regions and other asset classes.
The late Jack Bogle, founder of Vanguard, liked to call this the iron law of asset management: the average investor cannot sustainably outperform the broader market, and after fees is doomed to lose money, so the imperative must be to keep costs at a minimum. That reality is now belatedly sinking in, naturally leading to an irresistible, tectonic shift of money from traditional strategies to cheaper index-mimicking ones that is still in its infancy.
Fees have come under intense pressure in recent years, but remain high. The listed US asset management industry still enjoys a profit margin of more than 22 per cent — twice the S&P 500 average. That means there is plenty of room for prices to slide further. Index funds are pretty much the embodiment of Jeff Bezos’s famous quip that “your margin is my opportunity”.
No wonder then that Cyrus Taraporevala, the head of State Street Global Advisors, joked at the FT’s Future of Asset Management conference last week that the industry seemingly faced a crossroads between “one path leading to despair and utter hopelessness, the other to total extinction”.
Dr Burry’s argument that index funds make the equity market less efficient is not borne out by the evidence. In fact, it seems that on a broad perspective it is having the opposite impact.
By driving out poor and mediocre fund managers that in reality do little but charge expensive fees to hug their benchmark, markets become more efficient. The best analogy is a poker game where the poorer players lose their money and drop out first. That makes the game harder for the more skilled players that remain, not easier.
There are real questions about the instant liquidity promised by exchange traded funds and the underlying liquidity of some of their securities, especially at a time when trading conditions of many markets seem to have deteriorated. Yet there have been several major tests of the mechanics of ETFs in recent years, without any major mishaps. Perhaps the next big crisis will reveal unexpected fault lines, but they are as likely to crop up in the universe of active mutual and hedge funds.
Dr Burry’s more nuanced point — that the rising importance of index funds means that smaller companies that haven’t made it into one of the more popular benchmarks are unfairly shunned — is valid. Yet the bonds and stocks of tiny companies have always been largely ignored by most investors. Although the valuation gap between indexed heaven and below-benchmark hell is widening, likely due to index funds, this surely just means richer opportunities for money managers to exploit.
The bigger, still under-appreciated issue surrounding index funds are the benefits of scale and swelling corporate power that accrues to the biggest investment groups.
This is something that even Mr Bogle noted before passing away in January. But for the foreseeable future, the “index fund bubble” is a bubble that benefits every investor in the world. Long may it continue to inflate.
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