Passive Investing Gains Even in Turbulent Times
Exchange-traded funds were a source of stability for investors during the latest market selloff
By Jon Sindreu
Passive funds are cheaper and higher-yielding than their peers. Damningly for active investment managers, they may also turn out to be a better haven in turbulent times.
It’s been a volatile six months in markets, starting with a violent equity selloff at the end of last year and then a strong rebound into 2019. Money left active mutual funds en masse and has only timidly come back.
What is remarkable is that flows into passive funds haven’t missed a beat. Data by fund tracker Morningstar Direct show that exchange-traded funds, the most popular passive vehicle, recorded net inflows of $203 billion between September and January, while passive mutual funds received $167 billion. Meanwhile, almost $370 billion flowed out of active mutual funds.
It’s been a volatile six months in markets, starting with a violent equity selloff at the end of last year and then a strong rebound into 2019. Photo: Michael Nagle/Bloomberg News
One reason could be that many portfolio managers switched to ETFs, which are more liquid than individual stocks and bonds, precisely to escape the market rout. Bankers and fund managers have pointed to this pattern, and it has also emerged in recent surveys of institutional investors in the U.S. and Europe by research firm Greenwich Associates.
Another reason could be the profile of active fundholders: Investors who trust money managers to time the market may be more prone to demanding their cash back as soon as things go wrong.
Whatever the explanation, the continuing popularity of ETFs goes against the oft-repeated accusation that they appear safer in good times than they turn out to be during selloffs.
ETFs build a basket of assets to mimic some index, and finance it by issuing shares like any traded company. Active managers like to point out that ETFs are often more liquid than the underlying assets they own. If there is a market panic, it can be easier for investors to sell ETF shares than it is for the ETF to sell its holdings—which are then offered at a discount, worsening the selloff.
The theory has a kernel of truth: ETFs that track assets that are complex, very illiquid or hard to value should be handled carefully. Obscuring assets inside a wrapper rarely leads to good outcomes, as the credit derivative crisis in 2008 showed.
Yet there is little evidence of ETFs misfiring when they track simple assets such as stocks and bonds.
The real reason why ETFs scare active managers is commercial: Managers charge much higher fees for their services and yet have failed to deliver. In 2018, just 38% of active U.S. stock funds outperformed the average passive one—even less than in 2017, despite repeated claims that choppy waters help stock pickers find bargains. This year, half of all U.S. stocks could be owned by index funds for the first time, according to Morningstar.
ETFs have become a useful source of stability for investors in turbulent times—unless, of course, you are an active manager in fee negotiations.
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