Passive investment: the ‘do nothing’ revolution
The march of passive investment has been one of the defining themes of asset management over the past decade. But advisers warn that certain rich and risk-averse investors could run into trouble by relying too heavily on it.(1) So what is passive investment and why are experts warning of the disruption for asset managers?
Passive investing is an investment strategy that aims to maximise returns over the long run by keeping the amount of buying and selling to a minimum. The idea is to avoid the fees and the drag on performance that potentially occur from frequent trading. Passive investing is not aimed at making quick gains or at getting rich with one great bet, but rather on building slow, steady wealth over time.
Active investment is a strategy that relies on betting on the market. With markets becoming more efficient many people believe it’s no longer possible to pick stocks and beat the market. BlackRock and Vanguard responded to the new demand, with Vanguard creating the first index fund for retail investors in 1975. It’s an approach endorsed by legendary investor Warren Buffet, who thinks the smartest thing your money can do is climb into a hammock and take the rest of the day off. The active vs. passive debate rages on, with passive investment increasingly upending the industry. (2)
A decade ago the Chairman and CEO of Berkshire Hathaway made a million dollar bet that the S&P 500 "will absolutely kill every one of the fund of funds," and "passive investment in aggregate is going to beat active investment because of fees." After winning the bet last year the investor said “the date of the start has nothing to do with it” and is willing to make another bet on active versus passive investment. (3)
During the 1960s and 1970s, most actively managed ‘performance’ funds were able (more years than not and almost always over longer periods) to produce superior returns. Today, however, things have changed; actively managed funds are no longer beating the market. Over the 15-year period ending Dec. 2016, 92.15% of large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed their respective benchmarks.
Big-name fund houses known for picking stocks have recently felt the effect of passive investment. Goldman Sachs and Franklin Templeton both topped the list of the world’s worst selling fund managers. In 2017 investors pulled almost $2.7bn from Goldman’s fund arm while Franklin Templeton suffered redemptions of $21.6bn. BlackRock and Vanguard which are known for their passive fund ranges have been moving the other way and ranked as the best-selling fund houses in 2017 bringing in $223bn and $139bn respectively. (5)
With the rise in passive investment there has been significant opportunity for FinTech companies. The chief executive of Legg Mason, Joseph Sullivan, believes the Investment industry is facing a “hyper competitive and hyper disruptive period” with the rise of passive funds, increasing fee pressure and exponential technology growth. (6) Many investment groups are scrambling to unlock the potential of new technology and data sources to both improve their investment performance and trim costs by automating ‘back office’ processes, reshaping what the industry will look like in the future.
The asset management industry has traditionally been a “capital-light industry” which is an industry that has not needed a lot of investment in factories or research. This has begun to change though as companies invest into areas like machine learning, big data and cyber security. This has made passive investment more attractive; as markets become more efficient, passive investment thrives as no one has the information edge. “Investing in technology is now fundamental, and will materially impact every pillar of the business” according to Mr Sullivan. (7)
The winds of change are evident. Investors have wised up after a run of sub-par performance from active managers in this decade. They now recognise that the rise of low cost passives is a game changer that is intensifying price competition, margin compression and industry consolidation.
Michael Cowan joined FinTrU in 2016 through our third Financial Services Academy after graduating from Queen's University Belfast with an MEng in Chemical Engineering.
Since joining FinTrU Michael has worked on several projects, starting in compliance where he undertook due diligence for periodic reviews. He has since moved into investment banking where he is responsible for preparing daily reports for the senior management of corporate clients as well as investor targeting.