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The Rise of Index Investing Still Spooks Some Investors. It Shouldn’t.

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Brian Langstraat, CFA

Chief Executive Officer

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Index investing’s sharp rise in popularity over the past decade or so scares some people. And not in a fun, haunted-house kind of way. 

They see a darker, more malign force expanding across the investing community—something they blame for creating a so-called passive investing bubble, for somehow distorting the market, and for being, of all things, un-American.

None of those hobgoblins is true, of course. But that they continue to be told and believed isn’t surprising. Change is hard, after all. And press reports in September about passive equity mutual fund assets overtaking active equity mutual fund assets in the US for the first time probably didn’t help allay anyone’s fears. So as we celebrate Halloween, now seems as good a time as any to take a deep breath, unwrap a fun-size candy bar, and gain some perspective on what’s actually happening to investing—and what isn’t.

Bursting the “passive investing bubble”
The headlines in September were all about index-tracking US equity funds eclipsing their active counterparts for the first time—$4.271 trillion to $4.246 trillion, according to Morningstar. A somewhat notable milestone in investing history, to be sure, but a moment long anticipated. Was it also an indication of a dangerous bubble that will undermine the efficiency of capital markets? Hardly. 

It’s important to remember that, even with this symbolic changing of the guard, according to the Investment Company Institute, a trade association for funds, only about 17% of the US stock market is actually held in index funds. Looked at that way, isn’t it possible that we’re seeing, as  Robin Wigglesworth pointed out last month in the Financial Times, a long overdue deflating of an “active bubble”—one that “has expanded for nearly a century despite reams of evidence [and arithmetic logic] that most money managers underperform the market after fees”?

Does index investing distort prices?
In a word, no. If only 17% of the market is held in passively managed index funds, that means the vast majority of pricing decisions are being made by—yep, you guessed it—active managers. This makes sense, and it will continue to make sense even if index investing grows to 60%, 70%, or even 80% of equity market assets under management. Someone has to set prices, and in the equity market those someones are active managers. They argue about what to buy, what to sell, and when, and then vote with their dollars. Index investors merely buy into that consensus wisdom on the cheap, accepting the results that net out at the end of all those active bets.

In effect, the aggregate holdings of active managers comprise a market-cap-weighted index. So if index investors are accepting the aggregate holdings of active managers, by definition index investors can’t “distort” the market. They’re simply “being the market.”

Active management isn’t going away
Few investors, especially in the high-net-worth space, are 100% passive. They want portfolios that combine both approaches, with a keen eye for risk, fees, taxes, and performance that each approach, and a combination of both, can offer.

But what seems to be changing is how clients approach their portfolios. Whereas 20 or 30 years ago investors may have looked at index investing as an oddity—an experiment—and warily allocated a small percentage of their assets to it, now that equation has flipped. Many are opting to start with a low-cost index-based allocation and then, if and when they’re convinced of an active manager’s skill, will carve out a portion of their assets to deploy in the hunt for alpha.

What could that mean in a world with more index investors? Quite possibly more opportunities for smart, skillful active managers. There are, and will continue to be, active managers capable of exploiting market and security circumstances to their clients’ benefit. But the tension between an active manager’s fee structure and its ability to deliver alpha above and beyond those fees (and taxes) will also persist. 

What index investing’s rise means for financial advisors
There’s no question that the rise of index investing is changing the way financial advice is given. Advisors who in the past counted on their ability to pick stocks—or their ability to pick managers to pick stocks—to fully offset the fees and taxes their clients pay have had to adjust their approach. Finding the right mix of active and passive solutions for clients—while also building a financial plan, putting together the right asset allocation, reporting on performance, and considering clients’ estate planning needs and charitable gifting inclinations—is now paramount. 

In other words, it’s no longer enough for advisors to hang their hats on producing alpha. They can’t promise it, and over the long run most will find it elusive. Instead advisors are increasingly thriving by acknowledging that investing is changing; by making room in their practice for transparent, low-cost, rules-based products; and by beginning to redefine their value proposition to their clients. And, of course, we think advisors can capture additional benefits beyond commingled index mutual funds by offering their clients custom direct indexing solutions built around things like tax managementresponsible investing, and long-term exposures beyond cap weighting, such as factor investing.

The bottom line

Is index investing more popular among investors? Of course it is. Investors and advisors for decades have been increasingly compelled by indexing’s overwhelming logic. But is it distorting the market? Of course not. And will it prevent active managers and financial advisors from earning a living? Certainly not. It has and will continue to reshape conversations about investing, asking advisors to think realistically and holistically about what’s best for their clients. For many, this is ultimately careful planning, a focus on risk and costs, and a varied blend of active and passive strategies. And at the end of the day that’s not so scary, is it?

With additional contributions from Bob Breshock, managing director of distribution.

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