Rather than the traditional method of active investment, where one picks individual stocks to buy or sell, passive investment involves using an index or a collection of stocks, commonly known as a basket of stocks, to replicate the market portfolio. The advantages of passive investment are largely due to diversification, lower turnover and lower transaction costs. With a basket of stocks, one naturally has more diversification due to the inherent diversity of a basket replicating the market portfolio. Likewise, in tracking the market return, one does not need to constantly adjust his or her position in the market. Therefore, one does not need to worry about the transaction costs that come with adjusting one’s positions. Fundamentally, passive investment on average is more self-sufficient than active investment.
These advantages have allowed passive investment to consistently pull ahead of active investment. While active investment offers the possibilities of higher returns as opposed to passive investment’s restraint by the market return, active managers must reach a return greater than the market combined with their increased transaction costs. Active investment’s required return increases have been difficult to overcome. The Financial Times reports that, within a 10-year period, 83 percent of active funds in the U.S. fail to match their expected returns, 40 percent are terminated and 64 percent move away from their original styles of investment. Passive investment’s lower transaction costs have allowed it to offer a better risk return tradeoff than active investment.
While passive investment has consistently outperformed active investment, it cannot do everything active investment can. In order to keep low transactions costs, most indexes cover only large cap stocks to maintain low turnover. Because of this constraint to large cap stocks, passive investment leads to several types of risk. Passive investment is subject to the risk of large cap versus small cap stocks — a bull market in small cap stocks or a bear market in large cap stocks could put active investment returns ahead of their passive counterparts. Because it uses only large cap stocks, passive investment tends to follow the business cycle; in times of growth, returns on indexes are great, but recessions could easily inhibit passive investment. Time frames also matter. Passive investment cannot deliver the short-term returns of active investment, and it requires time for any market fluctuations to correct.
An increase in market power of passive investment funds may also cause certain unexpected problems. With an increase in the amount invested in indexes, the expectation is that this would cause increased correlation between stocks in different indexes. Likewise, an individual stock’s characteristics, such as membership in indexes or presence in exchanges will gain more importance in valuation over a firm’s operations or overall health.
Another issue is the measure of performance. A team from Goldman Sachs argued that stock returns and dividends are becoming increasingly inefficient measurements of performance due to the lower turnover of passive investments. With passive investment, returns and dividends are not solely determined by firm decisions. Boards must differentiate the “characteristic-driven” or “flow-driven” movements within their stock from fundamental ones in order to “better evaluate underlying corporate performance.” The team suggests that other measures, such as cash returns on investment or return on tangible equity, are more comparable across firms and better evaluate a firm’s health. Without taking these issues into consideration, passive investment can easily flip in performance given enough time.
The previously mentioned problems appear when passive investment gains a significant enough share of the market, and the evidence indicates that we are moving in that direction but are not quite there yet. According to Morningstar, an investment research firm, approximately $9.3 trillion is currently invested actively compared to the $5.5 trillion passively. However, those numbers have been shifting steadily. In 2016, Morningstar also reported that active funds experienced outflows of $285.2 billion while passive funds experienced inflows of $428.7 billion.
On the other hand, a study by Schaeffer’s Investment Research, a market information services and research firm, found, on average, stocks added to the NASDAQ 100 Index underperformed and averaged negative returns over the next year while stocks removed outperformed the index in the short term and stayed relatively on pace with the index in the long term. While the average returns of stocks removed from the NASDAQ 100 may be skewed due to data being limited to only stocks that were not bought out or did not go bankrupt, the underperforming average returns of stocks added to the index does imply an overvaluation. The overvaluation in this case suggests that investors have excessively optimistic expectations about stocks joining the index. In other words, investors on average overestimate the effect joining an index has on returns. The evidence signifies that passive investment has room to grow before their market power becomes a problem.
While the influence of passive investment has been increasing, it is not as large as expected. There has been no evidence that active investment on average will offer higher returns than passive investment within the near future. Even in the presence of a bear market, data shows that recessions affect active investment just the same (if not more) as they do passive investment. However, if passive investment gains enough steam with no change in structure, it is highly unlikely that passive investment will be able to maintain the success it currently has.