Active Investing vs Passive Index Investing

After the invention of the index fund by Jack Bogle in the mid-1970s, we have seen an explosion of assets for passive investment houses, such as Bogle’s Vanguard, Fidelity, and BlackRock, as their AuM swell into the trillions of dollars. Index funds have finally become the favorite child of the investing world, with assets in passive index investing strategies overtaking dollar volumes from actively-managed funds as of the end of the first quarter. The “set it and forget it” style of investing has become the popular choice for the majority of market participants. But now that we’ve seen index fund assets overtake active fund assets, and the volatility of the market so far this year, is this a good thing for investors?

Source: Yahoo! Finance

What is passive index investing? In 1975 Jack Bogle had an idea, the premise of which was that most people who wish to invest in the market would be better served in a simple, low-fee structured solution that only aimed to track overall market indexes like the S&P 500, as opposed to an actively managed fund with the goal of outperforming various indices. Originally seen as nonsensical by peers within the investment world, the idea clearly was able to gain traction, raking in trillions of dollars in assets under management and, in the long run, proven to be a popular solution among both the retail and institutional investor community.

What is active investing? We have previously explained that active investing is a strategy of investing where investment decisions are based on independent assessments of each investment’s worth. The goal of an active manager is to differentiate their fund and its underlying investments in order to outperform various indices or a standard benchmark. In essence, it is the opposite goal of index or passive investing. Oftentimes, however, many active managers (but not all) find themselves failing to beat their benchmark and generate the alpha Limited Partners pay exuberant fees for. Active investing is both an art and a science, requiring diligent fundamental research which often requires time and costly boots on the ground efforts, as well as frequent and nimble trading with the goal of capturing alpha. These factors result in higher expenses relative to passive strategies and thus may warrant active managers to charge higher fees relative to their passive counterpart.

Active vs Passive Investing: Is Ignorance Bliss?

There is no denying that the creation of the index fund has helped more people participate in markets than would have been possible without them. This is especially true within the United States, where index funds help make it possible for more than half of Americans to be invested in the stock market today, a larger share of population participation than many other wealthy nations. This proliferation, while good for investors over the past few decades, may lead to problems in the long haul.

According to the inventor of index investing himself, the rise in popularity may eventually have an adverse effect for investors. In a 2018 op-ed written for the Wall Street Journal, Bogle questions what may happen if index investing becomes too big for its own good, as even he believes that this innovation has its limits. He argues that the overconcentration of assets into these funds, combined with the assets held in active strategies managed by the same folks offering the index funds, will lead to the voting control of the majority of large corporations being in the hands of a very select few. Looking at the chart below from 2018 , you can see how we are already heading towards this end, with over 20% of total US stock ownership concentrated among only five asset management firms.

Passive Aggressive

Source: Wall Street Journal

For starters, as stated by Bogle, overconcentration would lead to voting power being controlled by a small number of individuals, who would hold practical power over the majority of these corporations. This would remove all governance capabilities of other public shareholders, leaving them at the mercy of the small elite group with voting powers. Elon Musk recently made his thoughts on the situation known as he echoed this sentiment, declaring on Twitter that “decisions are being made on behalf of actual shareholders that are contrary to their interests!” He bluntly summed up these thoughts in a confirmatory reply to Marc Andreessen, founder of famed Venture Capital Fund a16z, stating “there should be a shift back towards active investment. Passive has gone too far.”

Other concerns regarding the concentration of index investing assets include the effects it has on the stocks the funds hold, and the volatility that it may influence. Investors are voicing concerns that valuations are constantly rising regardless of merit, market corrections are becoming rarer and of shorter duration, larger stocks are outperforming due to their share within tracked indexes, and ultimately resulting in executive compensation soaring to unseen heights. “The tail is wagging the dog,” according to Vince Deluard, a macro strategist at StoneX Financial.

Of course, passive index investment funds drop right alongside the indexes that they track during market dislocations. And some believe that their concentration helps exacerbate these market swings. In this current market environment of 2022, we have seen major indexes plummet, causing billions in losses for those participating in index investing. But a bear market should have the opposite effect for active investing strategies, who should provide the most value for their investors during such times of dislocation. Active managers can utilize this environment to show that they have “more thoughtful risk positions around risk management and mitigation,” according to Neil Pardasani, Managing Director and Senior Partner at Boston Consulting Group. And according to Institutional Investor, some active investment strategies have begun to prove this thesis so far this year, helping relieve some of the pain wrought on by the Russia/Ukraine conflict, rising interest rates, and inflation concerns.

Active investing may be poised to take advantage of market distortions caused by the monolith of passive index investing. The concentration into index tracking should help create opportunities for managers who can spot bargains and avoid overpriced securities. Strategies that actively trade likely need to embrace the dislocations and prove their worth to investors by avoiding the tumbling of indexes this year. Index investing may be a suitable strategy for many investors, especially those who don’t mind just being along for the ride. But on the other hand, who wants to be a passenger when the driver is asleep at the wheel. As we expressed last year, maybe it's time to consider your mix of assets, and see what makes sense for your goals?

Sources:

1. Wall Street Journal, November 2018. “Bogle Sounds a Warning on Index Funds.”
2. Crystal Capital Partners, April 2021. “Active vs Passive Investing: Is Ignorance Bliss?”
3. Bloomberg, September 2021. “A Longtime Analyst Warns Dumb Index Cash Is ‘Tail Wagging Dog.’”
4. Bloomberg, November 2021. “Active v. Passive? Why It’s Not That Simple Anymore.”
5. CNBC, May 2022. “Elon Musk and Cathie Wood knock passive index investing, saying it’s gone too far.”
6. Yahoo! Finance, May 2022. “’The democratization of investing’: Index funds officially overtake active managers.”
7. Institutional Investor, May 2022. “The Bear Market Could Be the Last Best Chance for Active Managers to Prove Their Worth.”
8. Yahoo! Finance, May 2022. “Elon Musk Thinks Passive Investing “Has Gone Too Far;” Cathie Wood Agrees.”