A Bull Market in Passive Investing

Morningstar

The world has seen many changes over the past decade. In 2003 the Iraq War had just begun, Facebook (FB) didn't exist yet, and Barack Obama was just an unknown state senator from Illinois. In the financial world passive, or index-based, investing represented a relatively small slice of the mutual fund market while active management--in which mutual fund managers hand-pick securities for their portfolios--was the dominant model.

Ten years later, the scales are tilting more and more toward indexing and away from active management, particularly in some key areas of the market. There are several reasons for the increased interest in indexing among individual investors. These include studies showing just how difficult it is for active managers to consistently beat indexes over the long term, increased cost-consciousness (index funds tend to be far less expensive to own than their actively managed counterparts, giving them a leg up on performance), and the proliferation of index-based funds and ETFs that offer investors who prefer passive management more choices than ever before.

A Tectonic Shift in the Fund and ETF World
To illustrate investors' growing use of index funds, consider that on Nov. 1, 2003, 12% of all U.S. open-end mutual fund and ETF assets (not including fund-of-fund or money-market assets) were invested in passively managed products. Today that percentage stands at 27% and rising.

But this increased use of index funds and index ETFs has not been uniform across asset classes. Although investors are increasingly turning to passive management for both equity and fixed-income exposure, the trend is more profound on the equity side. In late 2003 U.S. equity fund and ETF investors held about 17% of assets in indexed products, but today that figure has more than doubled to 35% (figures do not include sector funds or funds of funds). The trend is even more pronounced in international equity, where the percentage of assets in indexed products jumped from 8% to 31% over the same time frame.

Use of passive management in the fixed-income arena also has grown impressively--expanding from 6% to 19% among taxable-bond funds and ETFs over the past decade--though it hasn't reached the level of equities. The fact that passively managed products are used to a greater degree for equity exposure than for fixed-income exposure might surprise some readers given that keeping costs low can be particularly important in fixed-income investing, where fees often take a larger relative bite out of returns than they do with stocks. It could be that recent uncertainty in the bond market, along with questions about the construction of some bond indexes (as discussed by Vanguard founder Jack Bogle in this video), has led to a reluctance on the part of fixed-income investors to use passive strategies and a continued preference for active management.

Passive Management Inside the Style Box
Drilling down further to the fund and ETF category level, additional patterns emerge. Let's start by looking at the domestic-equity categories. We'll use the nine categories that make up the Morningstar style box as our guide. Below are two grids--one for 2003, the other for 2013--that show the percentage of assets invested in passively managed (index) mutual funds and ETFs for each square of the style box.

One of the first things you might notice about the above chart is that passive management asset growth has been greatest in the three blend categories. This shouldn't come as any great surprise given that many investors who choose passively managed products are simply trying to capture market-level returns, and this is typically done using funds or ETFs that include growth, core, and value stocks--such as those that track the S&P 500 or a total stock market index--thus landing in the large-blend category.Funds and ETFs that use this blended approach are among the most popular. In fact, as of the end of November, index-based large-blend funds and ETFs held more than $1.15 trillion in assets, the most of any single fund category when broken down along active/passive lines. (In second place was actively managed large growth, at $1.10 trillion.)

A look at the left- and right-hand columns of the style box shows that passive management has gained a larger toehold among value-oriented funds and ETFs than growth-oriented ones. In fact, assets in passively managed large-value funds and ETFs have more than tripled over the past decade, whereas those in large-growth have merely doubled. (This rapid asset growth on the value side cannot be explained by outperformance, either. In fact, over the 10-year period ending Dec. 23, large-growth funds gained 7.6% per year on average while large-blend and large-value funds each gained 7.0%.)

Investors' use of passive management in the small- and mid-cap categories, which have much smaller asset bases than the large-cap categories, also has increased significantly, perhaps indicating that some investors who had previously used indexing for their large-cap holdings have turned to it for smaller-cap exposure as well.

Use of Passive Management in Other Categories
Next, let's take a look at how asset allocation among passively managed funds and ETFs in other key categories has changed over time.

Here we see a familiar pattern with the foreign large equity categories, with more than one-third of foreign large-blend assets today invested in index-based products and impressive growth not only there but in foreign large-value as well (and very little use of passive management in the foreign large-growth category).

Diversified emerging markets is even more explosive in terms of passive management growth, increasing from 13% of category assets in late 2003 to 44% now. You might find it surprising that so many investors have turned to indexing for emerging-markets equity exposure given the category's complexity and the perception that intensive research and active management might provide an advantage over indexing. Yet asset flows to index-based emerging-markets equity funds have grown prodigiously relative to those that are actively managed. Here, as with the domestic small-cap equity categories, it may be that investors who have used indexing for their core large-cap exposure--through an S&P 500 fund, for instance--have decided to apply the approach to their non-core holdings as well.

An Investing System for the Times?
Someone looking at the numbers above might conclude that the dramatic asset growth enjoyed by passively managed funds and ETFs compared with actively managed products simply reflects investors' changing tastes, but developments within the fund industry likely have played a role as well. For example, more financial advisors are moving away from a commission-based fee structure that rewards them for putting clients into load funds (typically actively managed ones) and toward a structure that pays them a percentage of assets under their management. In these cases, keeping investment costs low by using index-based products may ultimately help their own bottom lines. Also, in the wake of a financial crisis in which many actively managed funds that took on extra risk got hammered, some investors simply may have come to the conclusion that index funds are a safer bet.

There's something of a chicken-and-egg question at work here as well. The more investors seem to want passive management, the more the fund industry has reacted to that change. More recently, increasing attention has been paid to alternative indexing approaches--so-called smart beta--that are built around specific factors (stock price/earnings ratios, company performance, share-price volatility, to name a few). Some consider this a hybrid of indexing and active management styles.

Whether passive management will one day become the dominant investing approach, replacing active management, is difficult to say. Odds are there will always be a significant number of investors who are unwilling to settle for market-level returns, or who just like the idea of a human being making investing decisions for them rather than relying on an index.

But in a larger sense, the growing use of passive investment vehicles reflects the times in which we live. With algorithms helping determine which online ads we're exposed to each day and new metrics being invented all the time to aid in arenas as diverse as business, politics, and sports, perhaps it should come as no surprise that more people are willing to rely on an inexpensive, systematic, formula-based approach to investing rather than on the judgment and decision-making ability of a living, breathing fund manager.

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