We often speak of the difficulties that go hand in hand with choosing an active – or ‘judgmental’ – fund manager who will deliver market-beating returns.
Investors entrusting their capital to active managers risk an unnecessary transfer of their wealth in the form of high costs. They may also suffer the fate of returns lower than that of the benchmark over the longer term, evidenced by the track record of many active managers (For example, see SPIVA® U.S. Mid-Year 2020. https://www.spglobal.com/ ).
Recent history has seen investors transferring their wealth from active into typically lower cost index tracking funds.
Recent history has seen investors transferring their wealth from active into typically lower cost index tracking funds. This is good news for investors and the industry as a whole. Due to the lower cost solutions being used, investors should benefit from a lower cost drag and returns closer to the market. This move also gives an opportunity and incentive for the active management industry to focus on delivering better value at a lower cost to the end investor. Only time will tell the extent to which this becomes a reality.
Some critics argue that these flows pose risks to price discovery (i.e. stocks being properly priced). It is a truism that if investors continued to move from active to passive indefinitely that market prices would become dislocated from their true value, as everyone becomes a price taker and not a price maker. The reality is that price discovery is a function of the trading volume of active investors (i.e. how much is bought and sold each day) rather than their combined value. We are a long way from this phenomenon becoming an issue*.
Also, in a situation where market prices are incorrect opportunities will arise for active managers to harness these inefficiencies and outperform markets, after which money would flood back to actively managed funds to the point that the prices are once again fair. We live in an arbitrage-free world.
Our Investment Committee tirelessly reviews all new evidence that challenges or supports this approach. The current evidence suggests that focusing on a low cost and diversified approach gives investors a strong chance of experiencing a successful outcome.
* According to Vanguard, indexing represents up to around 5% of daily trading volume (at a push). Vanguard (2018) A drop in the bucket: Indexing’s share of US trading activity, April 2019
