Is Passive Management Creating a Market Bubble?
Since 2009, U.S. index funds have seen cash inflows of $1.7 trillion, while actively managed mutual funds have seen outflows of $1 trillion during the same period. The criticism of passively managed funds is that they lead to inflated valuations of the underlying assets of the fund. ETF’s and index funds are largely viewed as the perpetrators of a higher correlation of return across the current market. Theoretically, markets should work by aligning buyers and sellers and allowing them to negotiate the value of an asset. However, the value of an ETF or index fund is determined by the supply and demand of that particular fund; index funds and ETF’s invest over a broad range of securities, meaning high demand for a fund with a large long position on a security may artificially inflate the value of the security, and vice versa. These market drawbacks lead to divergences in market prices from the fundamental values of underlying securities.
The high correlation of returns across equities has made passive funds an appealing investment vehicle. Passive funds allow the ordinary investor to diversify across a broad range of securities in a manner once saved for institutional investors. Why should an ordinary investor pay an active manager when they can easily pick winners on their own? Doing so has been easy in a market that has yielded 35.32% (Dow Jones Industrial Average) and 27.27% (S&P 500) over the past twenty-four months.
An increasing number of ordinary investors are using these passively managed funds to manage their money. And why not? Today, the investment opportunities once reserved for institutional investors can be pursued by the typical American at a low cost. Vanguard 500 Index Investor has been up 33 out of 40 years. The Schwab S&P 500 Index Fund has a year-to-date return of 16.88% against an expense ratio of only 0.09% (compared to an average of 0.99% across passively managed funds.) To top it off, active managers aren’t even beating the benchmark! Active managers have failed to equal the worth of their fees as the market has risen to new levels. Fundamentalists cry out that the market does not reflect the underlying information. If the fundamentals are useless, what are you paying for?
The answer comes when the market begins to properly value independent securities. As correlations of asset returns regress to historical levels, active managers can prove their worth distinguishing the winners from the losers. Perhaps, a market downtown will change the wind and reverse flows back into active management. Passive management will surely hold a place in the market for long-term investors looking to minimize risk. The opportunity remains for active managers to prove their alpha before the market corrects any underlying distortions.