Seeking Alpha

Passive Index Investment Now Somewhere Near $20 Trillion

by: John M. Mason
John M. Mason
Banks, long-term horizon

Over the past decade, the flow of funds into global index funds has been enormous, and this movement has changed how financial markets and financial institutions perform.

It is expected that this trend will continue into the next decade, and based on historical examples, it is highly likely that "Big Tech" will continue to dominate stock performance.

Investors need to be aware of these factors because they impact the stability of markets, the oversight of investments, and the growth of global wealth.

“Assets managed by global index funds,” writes Robin Wigglesworth in the Financial Times, have smashed through the $10 trillion level, buoyed by rising markets and an investor exodus from pricier actively managed funds...”

At the end of November, the Investment Company Institute reported that the global industry reached a total of $11.4 trillion.

But, Mr. Wigglesworth continues, “Even this figure may understate the extent to which index investing has caught on. Many big pension funds, endowments and sovereign wealth funds have set up internal strategies that mimic markets without having to pay an asset manager.”

“Data on this is sparse, but BlackRock estimated in 2017 that such activity could amount to an additional $6.8 trillion.”

According to Morgan Stanley, about $1 trillion has left active equity funds over the past decade, and only the top decile of fund managers by performance has been able to retain assets during the period.

Performance is the driving force, since “Just 28 percent of US equity fund managers investing in large companies managed to beat the US stock market last year, and over the past decade a mere 11 percent managed to do so, according to Bank of America.”

One of the major reasons for this performance has been the performance of the United States economy over the past ten years or so and the Federal Reserve monetary policy that has supported the longest economic recovery in United States history.

At the beginning of the economic recovery, the Federal Reserve intentionally set out to create a wealth effect through rising stock prices that would produce an expansion in consumer spending that would serve as the foundation of the subsequent expansion.

During the recovery, the Federal Reserve continually signaled that it would, if anything, err on the side of monetary ease so as not to upset the expansion. Furthermore, investors took this position to keep the monetary spigot open as a kind of “put” for the stock market.

As a consequence, during the ten and one-half years of the current economic expansion, the US stock market has almost continuously risen and reached more and more new historic highs. The latest historic high was reached only last Thursday, January 2, 2020.

This has been almost the perfect world for passive investing. The statistics on the industry support this fact.

The question now shifts to one about the future. Given the performance of passive index investing over the past ten years or so, the question becomes one about whether or not passive investing will remain such a winner in the 2020s.

My answer to that question is that passive investing will continue to dominate more actively managed funds. My conclusion: “I do not see this environment changing any time soon. Therefore, I expect that investor funds will continue to flow into the passively managed portfolios from the more actively managed ones.”

But what, then, is going to be driving market movements in the new decade? Robin Wigglesworth has already started trying to unravel this mystery. He reflects on the past decade, pointing out “the big-fast-growing US technology stocks…utterly dominated equity returns in the 2010s.”

If the stock markets are going to provide any kind of performance similar to the one experience in the past ten years, some group (or groups) is (are) going to have to step up to provide the fuel for a future rise in the stock market.

“Although every major sector has enjoyed strong gains” in the market performance of the 2010s,” it is hard to overstate the importance of US tech stocks to the post-crisis market recovery.” Mr. Wigglesworth gives us some history. “Technology now accounts for over 25 percent of the US stock market’s value, making it the biggest sector by some distance. While its dominance pales next to that of energy and materials in the first three quarters of the 20th century - or that of railway stocks in the second half of the 19th - its position now seems hard to dislodge.”

That is, other sectors dominated the stock market in earlier periods and maintained their dominance for fifty to seventy-five years.

“Aside from a brief period in the mid-2000s when finance companies were flying high, the has been the largest US stock market sector since 1990.”

So, one could argue that technology stocks still have some time to run. There is room for the current dominant Big Tech firms to lead the market, although they may seem to be a little pricey right now. But there remain many “adjacent” areas that will prosper during the coming decade, and companies in these areas can provide the foundation for continued dominance of the technology space in the performance of the stock market.

Going forward, investors need to be aware of these trends, for they carry important messages about the possible performance of the stock market over the next ten years. The impact of this on the stock market will be confirmed by investment funds continuing to move into passive index funds.

If the size of global index funds is now around $20 trillion, how much can move into the industry over the next ten years? Another $10 trillion? What will this do to stock market performance?

Let the investment community beware.

Disclosure: I/we 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.