A subtle change is occurring in the investing world that we, at Rockbridge, have been noticing for some time. In fact, I am happy to see the trend accelerate. Investors are utilizing an increasing amount of market-tracking funds and ETFs, rather than using active management. Active management is the process of trying to outperform the market by buying the best securities and timing the market’s ups and downs. In other words, investors are realizing (and voting with their dollars) that active management is not worth the added costs.
The process of building portfolios is comprised of two distinct steps: (1) Asset Allocation and (2) Security Selection. Many investors have similar views on step one. However, there are two camps when it comes to the second step. In one camp investors believe experts exist who have the skill and superior ability to “beat the market” through active management. In the other camp, investors believe that there are bargains in the stock market, but it is either too costly or too difficult to accurately identify these companies before all other market participants. Instead, these investors focus their time on ensuring asset allocation is appropriate, utilizing market tracking (index) funds to mimic their desired asset class exposures.
There can be valid reasons for both approaches to security selection. For example, if all investors believed no relative value existed in active management, index funds would attract all investor capital. Opportunities to buy underpriced stocks should proliferate. In the opposing view, if all investors utilized active management, a “free ride” arises where participants get market exposure, by way of index funds, with comfort that every company is competitively priced.
Before John Bogle’s launch of the first index mutual fund in 1976, active management and stock picking were the status quo. However, now it appears that investors are taking notice that the odds are stacked against active managers. The Investment Company Institute, an association of regulated investment companies, analyzes trends in U.S. investment companies. According to data in their 2014 fact book, domestic index funds and domestic index-based ETFs saw net inflows of $499 Billion over the last five years, while actively managed domestic funds experienced outflows of $363 Billion. Although actively managed funds still have more assets under management, the difference is shrinking year after year.
The latest “SPIVA® U.S. Scorecard” report by Standard and Poors published in mid-2014 found that over the past five years more than 70% of active domestic equity managers across all capitalization and style categories failed to deliver returns higher than their respective benchmarks. The SPIVA® report measures the performance of active fund managers against relative benchmarks for different time periods. The findings may be evidence that investors are making smart decisions by pulling money out of actively managed funds and into index-based funds.