Passive Investing Hasn’t Taken Over the World
Ignore the hype. Actively managed money dwarfs the assets in low-cost index funds.
Bloomberg, October 1, 2019
The battle is over: Passive investing is victorious. Active management has been defeated.
By now, you surely know that Wall Street quakes at the mere mention of indexers, who devour all in front of them. Active managers, many of whom have since moved on to careers as Wal-Mart greeters or dental hygienists, are becoming as rare as the northern white rhinoceros. Once derided as “Bogle’s folly” – indexing’s inventor was Vanguard Group founder Jack Bogle – passive investing is now an unstoppable force, taking over everyone and everything in sight.
There is but one small problem with all of the above: It’s wrong. All of the technically accurate but misleading headlines fail to paint a complete picture. The hype about passive taking over the investing world is just that – hype.
Active management in the equity market, both in the U.S. and abroad, is dominant. And not by a little: Active management in the U.S. trounces passive by a ratio of 8-to-1 in dollar investments. Expand that to include the entire world, and the ratio is closer to 15-to-1. If we include fixed income in our calculations, the ratio balloons to 60-to-1. 2
So what’s all the hoopla about, then? In short, this is a story of money flows to mutual funds and exchange-traded funds (ETFs). 3 In the years since the financial crisis, investors have been pulling money out of underperforming, expensive active funds and sending them to cheaper, market-performing passive funds. Within that narrow space, the market share of passive index-based funds has grown to 51% of the $8.5 trillion in U.S. equity funds. Bloomberg News calculated the dollar amounts as $4.271 trillion in passive index funds, edging out the $4.246 trillion in actively managed ones.
But once you consider how all investable money is managed – and not just mutual funds and ETFs – the picture changes dramatically. Mutual funds and ETFs may be well-known among the public, but they are only a small part of the investing universe.
According to Fran Kinnery, global head of portfolio construction at Vanguard, there is about $35.6 trillion in publicly traded shares in the U.S. 4 That $4.271 trillion in passive index funds amounts to a 12% share of the total equity market. That’s about double what it was a decade ago, but far from dominant.
To be sure, that rising share is frightening for active money managers at pension funds, foundations, hedge funds and brokers. And full disclosure – I have personally been a beneficiary of the trend, with about 60% of my firm’s $1.1 billion in assets under management invested in passive stock and bond indexes.
Although passive investing has made significant inroads in the U.S., it is much less prevalent internationally. That may change over time, as investors overseas come to recognize the advantages of low-cost passive indexing. Regardless, add a reasonable estimate of non-U.S. index funds (about $1 trillion by my estimates) to U.S. passive equity funds, and the total of indexed equity capital rises to about $5.3 trillion worldwide. This puts the passive market share of global equity at about 6.4%. (Note, this excludes a variety of unknown holdings, including sovereign investment funds or separately managed accounts that might be passive. Include those, and global passive might be as high as 13%, according to Vanguard.)
But those are only equities – and rough estimates at that. If we include fixed-income investments, the percentages slide even further. Using the Securities Industry and Financial Markets Association Capital Markets Fact Book, we learn the total global bond market value outstanding is $102.8 trillion. According to Morningstar, $1.45 trillion of that is in passive bond funds. In other words the passive share is only 1.4%.
One last comparison. Fortune reports that index funds and ETFs produce “only $11 billion in fees a year by charging an average fee around 0.1%.” Active mutual funds, with almost identical assets, generate 10 times that amount – or about $120 billion in annual revenue. Add in the fees on the $3.15 trillion managed by hedge funds and you get another $45 billion in revenue.
The rise of passive indexing has been the most significant investment trend of the past decade. It is worth noting, however, that the total amount of money managed passively is a tiny share of the world’s total assets. Global equities are more than $82 trillion; fixed income is $103 trillion; there are trillions more invested in currencies, commodities and real estate. Passive may be making strong strides, but active management is how most of the investment assets in the world are managed today.
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1. There is no one definitive data set for the market capitalization of stocks and bonds around the world. I used a variety of sources, and while the totals never added up precisely, they were all pretty close: I used Vanguard for equity, fixed income and non-publicly traded company stock; Morningstar for equity and fixed-income flows (via Nir Kaissar); the Securities Industry and Financial Markets Association for global bond totals (via Dave Nadig); Russell Indexes for U.S. equity; and Savills for global real estate. These were reviewed against the Federal Reserve’s Z1 Financial Accounts of the United States.
2. For our purposes, we shall exclude private (non-public) corporate equity of about $15 to $20 trillion. Also excluded from the total: $217 trillion in global real estate; about $46 trillion of that is in U.S. residential and commercial real estate.
3. Commonly called 40 Act funds, a reference to the Investment Company Act of 1940.
4. Another proxy that could be used for U.S. equities is the Russell 3000; it covers most, but not all, U.S.-listed stocks. Guestimating your way to total U.S. market value generates a number similar to the one Vanguard comes up with: About $33 trillion for the Russell 3000 Index, plus another $2 or $3 trillion in equities and the non-trading stock of public companies.
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I originally published this at Bloomberg, October 1, 2019. All of my Bloomberg columns can be found here and here.
