Passive Investing

Passive investing has become much more popular over the last decade. According to data from Thomas Reuters, the ETF market is growing by nearly 30% a year. In addition, interest in EFTs and other passive investing options is expected to continue to grow rapidly for the foreseeable future.

Why is this? It appears the economic downturn played a key role. In addition, an aging population and changes in the structure of the financial markets may be drivers as well. However, the most important reason seems to be the increasing amount of data showing high-fee actively managed funds struggle to outperform passively managed indices.

Passive investing becomes more appealing

Passive and active management both appeal to different types of investors. Investors have always debated which approach was best. Passive investing was previously used primarily by institutional investors. However, it has recently become a popular option for individual investors as well.

There are a number of reasons passive investing is becoming more popular. Here are some benefits that appeal to many investors.

Lower costs

Passive investing used to be largely unavailable to most individual investors. However, with the advent of ETFs across a broad range of asset classes, passive investing has become a viable approach. In addition, the costs of ETFs have dropped considerably over the last few years, with some now charging fees below 0.1%. When compared to the costs of actively managed approaches, the cost differential is significant, often 1% or more.

Christopher Aldous, managing director of Charles Stanley Pan Asset, said that passive investing options with lower fees have made active management less appealing. He believes fewer investors will hire active managers as additional low-cost passive investing options are offered.

Growing pessimism towards active managers

Many investors have also become disillusioned with active money managers, because their performance hasn’t been very impressive. Numerous studies have shown few active managers are able to consistently beat the market. Nerd Wallet released a study last year that showed less than a quarter of active money managers were able to beat the market between 2002 and 2012. The study didn’t factor for survivorship bias, so the actual figure is realistically much lower.

NerdWallet cited high fees as the reason active money managers didn’t outperform indexes. The study showed the average active manager beat index returns by 0.12%, but charged average fees of slightly over 1%.

Wharton economics professor Lubos Pastor presented an alternative point of view in a 2012 study that claims investors tend to prefer active investing because they have the opportunity to take advantage of better trading opportunities. However, the data suggests they are gradually shifting towards passive investing instead as they realize they can earn higher overall returns.

More practical for baby boomers

Passive investing is also becoming more popular as baby boomers begin to retire. Alfred Kugel, a senior investment strategist for Stein Roe and Farnham predicted that passive investing was ideal for baby boomers back in 1996. Many baby boomers were worried about retirement and wanted to look for safer ways to grow their money.

More baby boomers are reaching retirement age each day, but aren’t confident they have enough money set aside to live comfortably. They are looking for diversified investing options to grow their money with as little risk as possible. Passive investing will likely become more popular as these baby boomers wrestle with funding their retirements.

Better tax efficiency

Passive investing options are also more tax efficient than most active approaches. Investors that choose to hold their money in an ETF or index fund minimize capital gains because there is little turnover in most of these funds. This allows them to grow their money more quickly. Many investors are likely to turn to passive investing as they become more aware of the consequences taxes have on their long-term returns.

Lower risk

Actively managed funds typically take on additional risk as they try to beat the market. This can present a problem for many individual investors, because they tend to be risk averse. The recent financial crisis has made them even more cautious, which has encouraged them to invest in ETF and other passive assets.

Passive investing also seems to appeal to many millennials. A recent study found that young adults have shied away from equities, because the recession has made them more cautious. Unfortunately, their reluctance to invest in riskier asset classes has made it more difficult for them to save for retirement. Passive investing may be a more appealing solution as they try to balance their aversion to risk with their need for greater returns.

Many investors have historically preferred active investing strategies. However, passive investing is quickly becoming a very popular option. Tim Strauts, Markets Research Manager for MorningStar, said that the percent of assets used for passive investing has increased from 6% to 36% over the past 20 years, and he believes the market for passive investing will continue to go higher over the coming years.

To summarize the primary causes of this shift:

  • Wide availability of ETFs across many asset classes
  • Low fees
  • Tax efficient
  • Better performance, mainly because of low fees and tax efficiency

Investors are realizing passive investing is not the same as settling for mediocrity, and the more people come to this conclusion, the more likely it is passive investing will continue its rapid growth.