Friend Or Foe? The Remarkable Growth Of Passive Investing

by: FTSE Russell

By Mary Fjelstad, senior research analyst

The word "passive" is probably one of the most innocuous words in the English language. One might, therefore, assume that investments described as passive would not be considered dangerous in any way. However, a quick Google search on "the dangers of passive investing" yields 300,000 links and over 10,000 from 2017 alone.[1] Focus on this topic has been driven by the enormous growth of passive investments over the last 18 years. In this and a subsequent blog post we will explore how passive investments have grown and the potential benefits and disadvantages this growth might present to the market and the economy overall.

For our purposes here, passive investments are defined as any investment in an open-ended mutual fund [OEF] or exchange traded fund (ETF) that is designed to replicate or track the performance of a broad-based capitalization-weighted index. We can see below that the passive market share of US equities has increased from just 12% in 1998 to 46% at the end of 2016. ETFs have been an important component of this growth, representing just 4% of the passive market at the beginning of the period to approximately 40% in 2016.[2]

What effect has this large shift away from active management had on the US equity market? William Sharpe's seminal work on the arithmetic of active management showed that a major benefit of passive investing is the potential for higher returns over active investments on average, due to lower associated management fees.[3] Research on international markets also provides evidence that the growth of index-based funds in non-US markets has been associated with declining active management fees, as well as a reduction in "closet" indexing by active managers (i.e. supposedly active funds that in fact track an index).[4] However, some have argued that passive investing could potentially lead to a decline in corporate governance and, even more concerning, to widespread security price-distortion.

This is a somewhat contentious issue which we have discussed in an earlier blog about the SNAP IPO in the US. At first glance, it is reasonable to suspect that passive investors would be less engaged in monitoring company management policies than active investors. Recent research, however, suggests that passive investors can actually have a positive impact on governance issues.[5] Institutional investors and mutual fund/ETF providers have, for example, responded to concerns by increasing the transparency and reporting of their governance policies and actions.

At the same time, passive investments have also run into considerable criticism for their presumed impact on security pricing. The criticism stems from the buy-and-hold nature of passive investments and the assumption that they do not add or remove stocks based on an estimation of securities' undervalued or overvalued status. Since the issue of security price-distortion is complex, we will explore it in greater detail in the next blog post on the growth of passive investing.

For more detail on this topic, please see the FTSE Russell research paper: "The growth of passive investing: Has there been an impact on the US equity market?"

[1] As of July 13, 2017;

[2] Source: Morningstar. Data as of March 22, 2017.

[3] Sharpe 1991.

[4] Cremers, M., A. Petajisto., and E. Zitzewitz, "Should benchmark indices have alpha? revisiting performance evaluation," 2012, Critical Finance Review.

[5] Appel, I.R., T. A. Gormley, and D. B. Keim, "Passive investors, not passive owners," 2016, Journal of Financial Economics, July.

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