Easy, Simple Money: The Explosion of Passive Investing

Are public equities fully valued, overvalued, or are there plenty of buying opportunities? What could happen to the price of fundamental commodities such as oil and precious metals, and how might this affect the markets? Only time will reveal the answers to these impactful questions, but one thing is very obvious: the current market sentiment is one of uncertainty. There is no obvious, logical answer to these questions and how the market might subsequently react; thus passive investing has grown monumentally in 2016 leading into 2017.

For some context, passive investing is not picking individual equities with the intention of outperforming the market, but rather investing in index funds (ETFs, Mutual Funds, etc.) that more closely track the performance of the market as a whole. Investors typically shift to forms of passive investing when they doubt their ability to outperform the market, seek a lower-risk, lower-reward model that simply tracks an index, and/or do not see value in alternative asset classes (as bond yields are virtually nonexistent, for example).

It is hard to determine that investors are truly losing confidence in their ability to pick individual stocks, but regardless, their shift to such funds suggest that they are content with portfolio managers who offer diversification at low managerial cost. Warren Buffett  believes “most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.” Buffett is renown for employing fundamental investing principles to achieve tremendous success. Over the last 12-18 months, the average investor who lacks extensive fundamental investing knowledge has migrated towards indices to generate a profit, as Buffet accurately predicts.

But why is passive investing on the rise at this moment? Broadly speaking, many believe that the equities markets overall will not provide substantive earnings growth in the following decades. GDP growth has slowed to 1-1.5%; these figures are not suggestive of attractive earnings for a long-term retiree. As a result, retirees have sought diversification across asset classes to achieve a benchmark annual return of perhaps 8%. However, those who have remained in public equities have chosen passive investments to mitigate risk and ensure a substantive return. Outsourcing this portfolio management in the form of passive investing has dominated the investing scene in 2016, and may continue to do so if of sluggish earnings reports continue. Increased offerings in diversification vehicles, such as ETFs and roboadvisers including Betterment, provide all investors with an easily accessible way to diversify their portfolio and perhaps track the S&P 500, which while growing marginally, continues to grow nonetheless.

Bill Miller, a prominent investor at Legg Mason Capital, believes that when this transition is complete, up to 70% of equity investments will be in different forms of passive investments. With this in mind, it is unsurprising to learn that investors placed over $200 billion into Vanguard index funds over the first 10 months of 2016 (!). Vanguard is projected to manage assets totaling over $4 trillion by the end of 2017, and rival Blackrock manages more than $5 trillion already.

Considering the current market conditions of volatility, I do not envision the passive investing trend to stop in the near future. The end to an exceedingly lengthy election season will reassure some investors, but the landscape of investing in public equities has yet to stabilize as America enters a phase of long-term, albeit marginal growth.

 

 

Referenced Material:

https://www.bloomberg.com/view/articles/2016-10-28/shift-from-active-to-passive-investing-isn-t-what-it-seems

http://www.wsj.com/articles/vanguard-receives-estimated-250-6-billion-u-s-net-inflows-through-october-1478107624

http://www.wsj.com/articles/are-fund-managers-doomed-making-the-case-for-passive-investings-triumph-1476798977

 

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