Synopsis: This research article, the first in a series, explains that the growth and development of index mutual funds and ETFs is attributable to evidence that most actively managed equity funds underperform their benchmarks due to the efficiency of the market and costs. That said, not all market segments are efficient and a case can be made for active investing, particularly in certain equity segments and the fixed-income sphere, where qualified active management and low costs can exploit these inefficiencies and add value.
Reliance on passive investing or indexing as part of a total investment strategy has gained widespread acceptance among institutional investors, including corporate and public pension funds, endowments, and foundations, as well as individual investors. This can be very clearly observed from the surge in the number and type of index funds, both mutual funds and ETFs, and their significant growth in assets under management.
According to data as of year-end 2015, the latest available as of the date of this writing, 406 index mutual funds managed total net assets in the amount of $2.2 trillion1. This represents a very significant 17% of total long-term mutual fund assets which stood at $12.9 trillion as of the same date. These include broad and narrower-based domestic equity-oriented indexes, domestic fixed income indexes, foreign stock and bond indexes and a variety of sector-oriented or specialty indexes that pursue technology, real estate, and utility sectors as well as sustainable investing. Equally important, demand for index mutual funds remains strong, with investors adding $166 billion in net new cash flow to these index funds. Triple digit net increases were observed in each of the previous three years. Refer to Exhibit 1. Ratifying this trend with even more current data, ETFs, which are largely composed of an index or passively managed funds, attracted record flows in 2016. For the year as a whole, $287.5 billion came into US-listed ETFs—the most ever. This brings total ETF assets at the end of 2016 to $2.6 trillion2.
Exhibit 1: Net Cash Flows into Index Mutual Funds: 2000 – 2015
Source: Investment Company Institute Fact Book 2016
What is an Index Fund?
An index fund is an investment vehicle that tries to match or replicate, as closely as possible, the aggregate price and dividend performance (total return performance) of an established target index or benchmark. The index, in turn, measures the movements of an unmanaged group of securities whose overall performance is used as a standard to measure investment performance. The fund does this by holding all, or a representative sample, of the securities that comprise the index. Affiliated indexes that are not widely recognized or used but are created specifically for replication purposes, which are now increasingly common, are also included in this category. On the other hand, funds that are not managed to a particular index, or deviate from a published index through stock selection policies, industry/sector weightings or credit quality parameters, are excluded from consideration.
Indexing strategies do not rely on traditional methods of active portfolio management that typically involve changes in the makeup of a portfolio of securities on the basis of economic, financial and market analysis in an attempt to outperform a particular benchmark or the market as a whole. Instead, index funds simply attempt to mirror what the target index does, for better or worse, and the only purchases and sales that are made (provided there is no new fund related sales, redemptions or distributions) are those necessary to create and maintain a portfolio that substantially replicates the selected index.
Active Management Can Exploit Market Inefficiencies
The argument for indexation is embedded in the belief that most active equity managers fail to outperform securities market indexes, especially after management fees and expenses, such as trading costs, are factored in. To a somewhat lesser degree, this argument is also applied to bond managers. This is due to the efficiency of the market, expressed in the form of the efficient market hypothesis which states that it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. As such, all stocks are fully discounted for expected future events such that profit opportunities for active portfolio managers are severely restricted if not entirely eliminated.
One study for example, published by Vanguard Research in early 2013that focused on equity funds, showed that over a twenty year period, less than 25% of actively managed US equity mutual funds outperformed their relevant style benchmarks. Vanguard’s research further found that such underperformance is relatively consistent across various countries, market segments and time periods. More recent research published by S&P Dow Jones Indices also confirm that within domestic equity, the majority of managers in nearly every category tend to underperform their respective benchmarks. This applies to both retail and institutional funds. In fixed income, including both taxable and municipal sectors, the finding are mixed depending on the market segment.
Indeed, it is acknowledged that some segments of the financial markets are less efficient than others and in these less efficient segments of the market, in combination with certain technical considerations as well as low-to-lower fees, a case can be made for active management. These cover, for example, small capitalization stock segments, emerging markets and fixed income sectors, including certain less efficient subsectors, such as municipals, high yield, loan participation and MBS, to mention just a few that may fall into this category.
With regard to fixed income, in particular, certain segments of the market are opaque and relatively illiquid. Unlike equities, there is no central exchange for trading fixed-income securities, and many fixed-income securities do not trade with anywhere near the frequency of equities. As such, there is no central pricing mechanism for fixed-income securities. This becomes even more pronounced the further away you stray from highly rated more liquid sovereign or government debt. Once you get into municipals, junk bonds, senior loans or floating rate securities, there is significantly less pricing consensus. In this instance, active management can add value by leveraging credit analysis and analyst judgments.
Technical considerations can also contribute to the ability on the part of active managers to add value. Fixed income indexes are very large and they include illiquid securities as well as multiple bonds issued by the same issuer. Active managers have the discretion to pick a limited number of such securities that are deemed to be most attractive. Further, fixed income indexes are market value weighted. But rather than reflecting a company’s market capitalization as is the case with equity indexes, these reflect a corporation’s appetite to borrow rather than their capacity to service their debts. Active managers can circumvent this issue by using their own proprietary fundamental analysis to pick higher-quality credits. Further, managers have the flexibility to buy issues that are not in the index or load up on bonds that might be upgraded substantially if the issuer were acquired by another company with a higher credit rating.
Such inefficiencies represent pockets of opportunity that pave the way for investors to achieve incremental results, or above benchmark returns, through active management. Importantly, this involves selecting skilled managers with an established and consistent track record offering funds or other investment products that are priced at the low or lower-end of the range.
Future articles will explore various additional facets of this issue.
This hypothesis is widely accepted for segments of the market that are considered efficient. But this is not necessarily the case for less efficient market segments, such as emerging markets, investment grade fixed income, high yield or municipals, to mention just a few, where credit analysis and analyst judgments can add value. In the same way, active management in the fixed-income sphere has the potential to outperform fixed income market value oriented indexes that reflect a corporation’s appetite to borrow rather than their capacity to service their debts. Managers have the flexibility to buy issues that are not in the index or load up on bonds that might be upgraded substantially if the issuer were acquired by another company with a higher credit rating.
While the data show that active managers struggle to outperform the market—net of fees—there are pockets of the market where a case can be made for active investing. For example, fixed income is a notoriously opaque and relatively illiquid marketplace. Unlike with equities, there’s no central exchange for trading fixed-income securities, and many fixed-income securities do not trade with anywhere near the frequency of equities. As such, there is no central pricing mechanism for fixed-income securities. This becomes even more pronounced the further away from sovereign debt you go. Once you get into municipals, junk bonds, senior loans or floating rate securities, there’s significantly less pricing consensus.
As such, there’s some merit to the idea that superior managers and analysis can generate outperformance in these markets. In addition, the neutral weighting mechanism in fixed income is valued weighting, whereby the bonds with the highest outstanding face value receive the highest weighting in an index. This means the biggest debtors are given the highest weightings. Active managers can circumvent this issue by using their own proprietary fundamental analysis to pick higher-quality credits.
Still, these instances are the exception rather than the rule. History tells us that real outperformance is fleeting, not durable. Those managers who outperform one year are typically next year’s underperformers. Passive investing captures the market in a cost-effective, efficient manner.