Author: Tim Courtney
Weekly Commentary October 18, 2019
For the first time ever, assets in U.S. index-based equity mutual funds and ETFs have surpassed those in active funds. As of Aug. 31, 2019, passive U.S. stock funds hit $4.27 trillion in assets, eclipsing the $4.25 trillion in their active counterparts.1
Active funds are generally understood as having a manager or a team of managers make decisions based on research and analysis. Passive funds are funds that have no manager but are constructed using a set of predetermined quantitative rules. The distinction between active and passive has been blurred in recent years with many funds having elements of both in their strategies.
Passive funds got their start in the 1970s, but really took off in 2009 as the current bull market began.1 Many of the new funds that have come to the market in the last 10 years are passive in nature.
While index funds2 present a wealth of opportunities for the investing public, especially cost savings, it’s important that we step back and look at the repercussions of this industry shift.
Now, because cash flows are being dominated by indexing, many active managers feel they are forced to incorporate the positions held by passive funds into their strategies so they don’t fall behind in performance. In turn, this has caused a huge focus on the largest 50 companies in the U.S.3 As these companies get larger, passive investors are required to buy more stock in them.
While the “big get bigger,” however, many areas of the market are being excluded. International assets and value stocks are examples of strategies that have underperformed during this period of passive acceleration.
As investors, it’s important that we constantly look for areas of opportunity in the market and refrain from putting all our focus on a single market-capitalization strategy. History has shown that while these trends may continue for some time, markets don’t move in a singular direction for long. A great example of this was the “Nifty-50” stocks4 in the 1970s that dominated returns in the market, until they didn’t.
At Exencial, we see value in passive investing, but also believe it’s still critical to remain diversified and include other strategies so that when passive, market-cap weighted strategies like the S&P 5005 falter – as they did in the early 2000s6 – we have exposure to other strategies they will behave differently. The 50 largest companies in the U.S. have done well recently, but these specific leaders are not representative of the entire market. There are several sectors (e.g., financials and energy) that haven’t participated in recent market growth to a large extent and yet shouldn’t be ignored.7
While the turning of the industry tide is not necessarily a bad thing, as investors we need to know that having some strategies that won’t behave just like the market-cap strategies can be a helpful way to invest.
1. Bloomberg – End of era: Passive equity
funds surpass active in epic shift
2. Investopedia – Index fund
3. Forbes – America's largest public companies in 2019
4. Forbes – Are any of the 'Nifty 50' stocks still nifty?
5. Yahoo! Finance – S&P 500
6. Investopedia – The Great Recession
7. Forbes – The energy sector lagged in the third quarter
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