The Success Of Indexing Is Helping Active Investors

by: Larry Swedroe

The mutual fund industry has grown dramatically over the last half century across the world. At the end of 2010, there were nearly 25,000 equity funds and $10 trillion in assets under management. There's also been dramatic changes in the relative amounts of passive versus active management, with the percentage invested in indexed equity funds - index funds and exchange-traded funds (ETFs) - growing from about 14 percent of global assets under management in 2002 to about 22 percent in 2010.

Index funds provide investors with a low-cost way to obtain exposure to both beta (stock market risk) and other factors that explain returns (such as size, value and momentum). In the U.S., the market share of indexed funds grew from 16 percent of assets under management in 2002 to 27 percent in 2010. For funds domiciled in other countries, indexing is less common but has been growing faster, from 6 percent in 2002 to 13 percent in 2010.

Interestingly, the U.S. is not even close to having the highest level of indexing. Switzerland takes the honor with more than 58 percent of assets being indexed. Ireland comes in second with an indexing share of 31 percent.

Also of note is that the popularity of indexing rose after the 2007-2008 financial crisis - when active management failed on its "promise" of protecting investors from bear markets. While assets under management by active funds dropped during the financial crisis (from $7 trillion in 2007 to $6.2 trillion at the end of 2010), indexed assets actually grew over the crisis period (from $1.3 trillion to $1.7 trillion).

The authors of the study The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance, examined the relationship between indexing and active management in the mutual fund industry worldwide. Using a new data set on open-end equity mutual funds and exchange-traded funds (ETFs) in 32 countries from 2002 to 2010 they found some interesting results:

  • Indexing is rare in countries with weak regulation and less developed financial markets. In such markets, many actively managed funds engage in closet indexing (there's little differentiation between the active fund's holdings and that of their benchmark index - they have low "active shares").
  • Actively managed funds are more active and charge lower fees when they face more competitive pressure from indexed funds.

Specifically, they found that closet indexing is common, especially in mutual fund markets outside the United States. Defining closet indexers as funds with an active share below 60 percent, they found that outside the United States about 30 percent of the assets are managed by closet indexers, twice the level of closet indexing that prevails in the United States. The authors concluded that increased competition from indexing results in active fund managers differentiating themselves more from their benchmarks. They also found that active funds charge lower fees in markets with a higher presence of low-cost explicitly indexed funds.

They also found that active funds tend to charge higher fees in countries where closet indexing is more pervasive. And in most countries of domicile, closet indexers are as costly as truly active funds, with each having an average total cost of about 1.65 percent.

The authors concluded that the higher competitive pressure created by the presence of low-cost passive funds in the market leads their active fund rivals to differentiate more.

The bottom line is that active investors are actually benefiting from the success of indexing. The competition is driving down fees. And it is costs, not poor stock selection, that causes active management to be the loser's game.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.