Indexing, Passive Management Trounce The Competition

Financial advisors looking to squeeze higher yields out of client portfolios in an era of low interest rates have two options. They can follow a passive investment management strategy or defer to an active investment approach.

Passive investment management, or indexing, has buried its greatest investment strategy rival, active management, in terms of recent asset volume growth.

But the triumph of passive management is no accident.

The relentless pressure on lower fees, combined with a seven-year-long bull market, have helped passive investing surge even further.

Since the 2008 financial crisis, passive investment strategies have gained in popularity. However,  there was talk earlier this year that active strategies might recapture their luster. This talk was prompted by improving economic fortunes that fueled rumors of an interest rate hike and even the end to the bull market dating back to March 2009.

But that all seems to have vanished. Recent gains since the Nov. 8 election of Donald J. Trump only seem to have boosted equities.

“The Trump election has changed everything,” said Chris Brown, founder of Sway Research, a consulting firm that analyzes defined contribution investment plans.

“A lot of people I talked to in the past six months thought we were headed into a bear market with higher interest rates, but with Trump I don’t know,” Brown said. “We might be on a little bit of run now.”

The Standard and Poor’s 500 index is up 7.9 percent for the year after Tuesday’s close, and the bull run may still have legs.

Trump’s intention to cut corporate taxes could signal more good news for equity index funds, analysts say.

“Passive is up, active is down,” said Chip Roame, managing partner of Tiburon Strategic Advisors. “It’s a pretty clear story.”

In a passive approach to investment management, managers seek to track, not necessarily surpass, an investment benchmark. Lower fees and fewer transaction costs erode little of the investment returns delivered by a rising market.

Active approaches to investment management, by contrast, tend to deliver higher value during bear markets as benchmarks endure falling cycles.

The Great Steamroller

Since the 2008 crash, open-end mutual funds and exchange traded funds have benefited from in-flows of $961 billion, while actively managed funds have seen outflows of $600 billion, according to Tiburon Research.

Vanguard Group dwarfs the rest of the industry with 19.2 percent of mutual fund company assets under management at the end of March. This is more than double the assets under management by its closest competitor Fidelity Investments, Tiburon data show.

Roame said Vanguard had collected $224 billion worth of in-flows over the 12-month period ended May 31. This compares with outflows of $137 billion over the period from all other mutual fund and exchange trade fund companies combined.

After taxes and fees, very few fund managers beat the indexes. Investors see little value in paying for active management in a rising market.

Brown said that he has never seen so much attention paid to fees and costs. He said this is either because of excessive-fee lawsuits filed against retirement plan sponsors and advisors, or because regulators have decided to take a harder line against costs.

On average, passive funds deliver an asset-weighted expense ratio of 0.20 percent, more than half the 0.44 percent they charged in 1990, Roame said.

Actively managed funds, on average, deliver an expense ratio of 0.79 percent, slightly lower than 0.99 percent they charged in 1994, he said.

Even active managers need to show they can deliver at lower costs: More than half of all the money in actively managed mutual funds has gone to the 10 percent of mutual funds with the lowest expense ratios, Tiburon research has found.

Whether in the active or passive world, fund fees are coming down.

Not that active management is dead.

Brown said plenty of market segments lend themselves more readily to active strategies for which management can justify a higher fee. Fixed income is one example of one of those segments, which depend on bond quality, duration and interest rate variables.

Appeal of Hedge Funds, Liquid Alts Wane

Over the past four years, the rise of passive investment strategies seems to have mirrored the retreat of hedge funds and “liquid alternative” investments.

About two-thirds of the hedge funds listed in a major commercial database failed within three years, according to Roame’s analysis of 2014 data from the Imperial College Center for Hedge Funds Research.

Almost half – 48 percent – of financial advisors do not recommend hedge funds to clients but would consider recommending them in the future, according to a 2014 survey.

With some big-name hedge fund titans fined by U.S. regulators in recent years, the sheen has come off a secretive industry run as a private club where the barrier to investment entry is measured in the millions of dollars.

Big insurance company investors including MetLife, American International Group and giant New York and California employee pension plans have noticed.

AIG earlier this year said it planned to pull about half of its $11 billion in hedge fund holdings. MetLife, with about $1.8 billion invested in hedge funds, has been sending out redemption notices to hedge fund managers, according to a June article in The New York Times.

“We had a very negative experience in hedge funds,” AIG CEO Peter D. Hancock said in a meeting with investors earlier this year.

Hedge funds gained popularity by promising high returns, noncorrelated returns and exclusivity, but they simply haven’t delivered, Roame said.

Despite subpar performance, hedge funds still manage to raise a lot of money. Hedge funds and liquid alternative managers controlled $3.2 trillion at the end of 2015. That was nearly double the $1.7 trillion under management in 2007, a year before the financial collapse.

Asset flows into liquid alternative mutual funds, however, appear to be in rapid decline from a high of $96 billion in 2013 to $3.1 billion in 2015.

Assets under management in liquid alternative funds have leveled off at $309.2 billion at the end of 2015, down slightly from $310.4 billion in 2014, Tiburon research found.

InsuranceNewsNet Senior Writer Cyril Tuohy has covered the financial services industry for more than 15 years. Cyril may be reached at [email protected].
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