Executive Summary
The rise of Vanguard and ETFs in the past decade has been nothing short of astonishing, with trillions of inflows to ETF assets, and Vanguard adding more assets in the past 5 years than they did cumulatively in their first 35. Yet the question arises: why was it that made the past decade or two the rise of passive investing. Why didn't it happen sooner? Why did it take Vanguard decades for the idea of the index fund to really gain traction?
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, I offer an 'alternative' explanation for the rise of passive investing, that has little to do with the performance of passive vs active itself. Instead, I think the real catalyst that changed the flows from active to passive funds was the internet.
Because the reality is that before the internet, the average investor didn't have the tools to know that so many actively managed mutual funds underperformed their benchmarks, and how to select which were the few funds that were actually good. Instead, most investors could only look at quarterly statements, or the Wall Street Journal's pages of stock prices, and figure out that they had "made money" because the investment was up. But not actually whether it was up more or less than it should have been, given peer comparisons.
With the rise of the internet, though, the tools suddenly became widely available. Investors could actually do real performance benchmarking and cost comparisons for the first time. The tools were finally available to shine a bright light on relative mutual fund performance, and easily identify the laggards. The technology was a transformative moment for real transparency on performance, and putting it into an easily usable format.
And now the trend only continues, likely to be accelerated by the DoL fiduciary rule, which will require all financial advisors working with retirement accounts to use those kinds of tools to do their own investment due diligence. While DoL fiduciary didn't ban commissions, it does require a recommendation that non-commissioned prudent expert would have also suggested, which means advisors who sell commissioned products have a substantial burden to prove why they're that good.
In fact, the ultimately conclusion of this trend may actually be a tremendous consolidation of the entire ETF and index fund world. Because the reality is that with transparent tools to make it easier than ever to find the best - which when it comes to commoditized index funds, is often nothing more than a comparison of which is the cheapest - there's no longer a need for 100 ETFs to track an index, nor 10, nor even three. Instead, these are "winner takes all" markets - which is exactly why the ETF price wars are underway, and are likely to continue for the foreseeable future.
All caused by the transparency that good technology brings!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces!
Today I want to talk about the ongoing shift from actively managed mutual funds to passive funds.
It's no secret that flows to passive funds are on the rise as actively managed funds in the aggregate are contracting. The Wall Street Journal had an interesting article this week about the "death" of the stock picking business, where they noted based on Morningstar data that $1.3 trillion has been flowing into passive vehicles over the past three years, while a quarter of a trillion dollars ($250 billion) was leaving actively managed funds at that same time.
What that means is that not only are we buying passive with our new dollars - so the inflows to passive are much bigger than active - but we're now actually starting to proactively sell active funds to rotate into passive. The net flows out of active are negative, while passive flows are about five times as large!
Some have suggested this is being driven by shifting consumer preferences for passive investments given their lower cost. While others have questioned whether this is the result of the rise of the AUM model – particularly amongst IRAs who don't have any financial incentive to sell actively managed mutual funds, and are instead just picking simpler, lower cost ETFs.
I've even suggested in the past on this blog that part of the shift is happening because as investment costs compress advisers are disintermediating fund managers. In essence, advisors are saying, "I'm going to manage the portfolio myself to help justify my AUM fee, and since stock trading is too intensive, I'm going to use ETFs. But this lets me pull that fund manager out of the picture, so I can save my client the fund manager's cost, and have the client just pay me." That's not actually a shift to passive. It's actually a shift of where the active is occurring, and which building blocks are being used (ETFs vs individual stocks), but ultimately it's still driving flows to passive vehicles.
However, the problem with these explanation is that in reality investment costs have been coming down for decades. It's not a new phenomenon of just the past 10 years. Markets have been getting more efficient for decades, and there have been advisers trying to take money away from sales people for decades. None of this is actually new.
And that raises, to me, the question of what has changed over the past 10 or 15 years that has made this suddenly the point that actively managed funds would really begin to topple, and indexing would begin to rise?
I think the real reason that actively managed funds are dying now is, to put it in one word, the internet. The internet did it.
And here's why.
How Investors Historically Evaluated Active Mutual Fund Performance [Time - 3:18]
First of all, to understand whta's changed, it is important to recognize how investment managers, or rather their investment performance, were evaluated before the internet showed up.
If you were the average consumer, you only knew how you were doing about once a quarter... when your brokerage firm mailed you a statement. You opened your mailbox, you pulled out the statement, you opened up the statement, and it told you your account balance, and you could see whether you were up or down. Maybe it gave you year-to-date performance so you had some return calculation, but even if it did, that return wasn't compared to anything useful. So for most people, the only way they evaluated their investment performance was through one simple version of benchmarking that anybody could do in their head: Is it worth more now, than it was last time I looked at my statement? Or at least, is it worth more now than it was when I bought it originally?
Throughout the 1980's and 1990's, which was the rise of the active managed fund complex, the answer was virtually always yes. When you got your statement, you saw you had more money than the last statement, because it was a raging bull market for 20 years.
Those who wanted to monitor things more closely could go one step further: The Wall Street Journal. Every day the Wall Street Journal had pages and pages showing prior day closing prices for most stocks and mutual funds, so you could see how you were doing. Though again, it was just prices. You could look up prices. If your prices were higher than last time you looked in the newspaper, you were feeling pretty good. But no one really knew how to compare.
For instance, if one large cap fund appreciated $4 dollars from $39 to $43 and a second fund was up $5 from $56 to $61, most people couldn't do the math in their head to figure out whether the first one was actually doing better than the second one. They might see the second one was up $5, and the first one was up $4, but the second one had a larger price to begin with... and most people can't do the math in their head to figure out that the second one with the $5 rise was actually only up 8.9%, while the second with the $4 increase was up 10.3%. That's just not performance calculation math we can do in our head.
Which means basically, most people had no idea how their active managers were actually doing, compared to any relevant alternative, like an index! There really were no effective comparisons going on between funds to figure out whether they were actually doing a good job beyond just going up in value. Then the internet showed up, and it all changed.
How The Internet Changed The Performance Benchmarking For Active Mutual Funds [Time - 5:18]
With the internet, for the first time, it was possible to look up more than just closing stock prices or the NAV of a fund to see if it was up. You could actually compare funds to one another with actual performance data. In the early days, there were platforms like BigCharts and ClearStation. Then Yahoo Finance showed up, along with a whole bunch of others, that would let you compare funds, for the first time, based on actual performance data.
This was at the same time that Morningstar.com got going, and turned what was originally a niche service distributed in print to a subset of individual investors who wanted to benchmark their investments, into a more widespread and easily accessible solution.
And once we saw the data - once we got that level of transparency - we learned for the first time that, frankly, a lot of actively managed funds kind of sucked! Not all of them, but a non-trivial number were not actually good performers. They were generating absolute positive returns, but they were terrible compared to others in their category.
But before this moment, when the internet gave us the tools to discover that information, we just didn't know! Because statements showed prices, the stock pages showed prices, and we couldn't easily calculate performance in our heads. And most people didn't have any other tools. Not to mention more nuanced evaluation problems, such as miscategorizing funds - for instance, we might have compare small caps against large caps and mistaken a fund's "good" performance for what was really just a year that small cap outperformed large cap.
But again, the rise of online tools - as well as the rise of the Morningstar style box - made it accessible for so many more people to figure out what was actually a good fund, and what was just a fund that was along for the ride and going up at a rate that was actually less than everything else in its category.
On top of that, the transparency of the internet meant you could finally look up costs in one consolidated place. Granted, those costs were always available in a 172-page prospectus before, but now you could easily, in one central place, view the costs of all of your investment options. You could even screen out potential investments based on costs, and just pick which ones you wanted.
So simply put: the internet made it possible, for the first time, for the average investor to easily do real performance benchmarking and cost analysis. And once the tools and transparency showed up... well, since then we're just watching market forces sort themselves out!
How The Internet Altered The Search For Mutual Funds And ETFs [Time - 7:34]
The second important thing about the impact of the internet on evaluating funds is that it not only became possible to evaluate existing funds, but information available to evaluate new funds was more accessible than ever. In other words, this isn't just about figuring out how your current funds were doing... it was also about identifying where your next savings or investment dollars would go. Having tools that gave you transparent information on performance benchmarking and cost revealed that many actively managed funds weren't actually any better. Some were just being sold because someone was being paid to sell them (sometimes under the guise of "financial advice", though at the end of the day, the person was a mutual funds salesperson).
As the tools became available, suddenly consumers could directly screen good from bad funds. Furthermore, the rise of online brokerage platforms – from Schwab to E*Trade – meant that not only could consumers evaluate their funds, but they didn't have to pay a mutual fund salesperson (an intermediary) to buy them. And now that a segment of investors weren't being steered by mutual fund salespeople towards more expensive funds (more expensive in part because of the commissions that would go to those salespeople), and instead those investors could directly buy no-load funds that stripped out the distribution costs altogether. Thus, we saw the further rise of Vanguard, and the rise of ETFs – the rise of fund solutions that have better performance because they're cheaper, and they're cheaper because they're not distributing through sales people that need to get paid commissions.
And again, with the transparency of internet-based tools and technology, the average investor could figure all of this out for the first time. In fact, we can even see this spilling back over to financial advisors today - with advisors increasingly being forced to actually deliver real advice to earn their compensation, because just filling in an investor's portfolio with the latest mutual fund products doesn't cut it anymore.
How DoL Fiduciary Will Only Accelerate The Technology Transparency Trend [Time - 9:10]
With DoL fiduciary coming next year, it's important to recognize that this trend isn't changing any time soon. In fact, I think it's going to accelerate because, once you unleash this kind of transparency through technology, it's almost impossible to close Pandora's box.
Under DoL fiduciary, if advisors are actually calling themselves advisors, they're going to be held accountable as advisors to recommend solutions that other prudent experts would recommend (because that's what a "best interests" standard actually requires!).
This means the advisor can't sell a mediocre, overly-expensive active fund just to get the commission anymore. We could before, as long as the underlying investment was at least suitable (or not UNsuitable) to the investor's needs. But no fiduciary recommends a sub-optimal, poorly performing mutual fund that just happens to be suitable and pays a good commission. That won't work anymore.
Notably, you can still have commissions under BICE (under the Best Interest Contract Exemption), but they still have to actually be good funds. If the adviser fails to do the due diligence on a fund, now the adviser is liable.
So the pressure is on across the board for everybody to use all these tools we have available to vet which funds are actually good, using real cost analysis and real performance benchmarking. That doesn't mean actively managed funds are completely dead, but I do suspect it means only a small subset of active funds that can really demonstrate their value are going to survive. The rest are basically doomed, at least in retirement accounts where DoL fiduciary duty applies.
Technology + Transparency + Fiduciary = Winner-Takes-All Markets [Time - 10:41]
The last notable thing about this trend is that the combination of technology and transparency still have a lot further to go in transforming markets.
Because the truth is that with tools to make it this easy to transparently analyze results, only a minuscule subset of the best solutions are going to win. And the ones that do, are going to win almost everything.
I think that's why Vanguard is so dominating the landscape already. So many ETFs are a commodity. When they are all tracking the same index, you really don't need 100, or 10, or even three ETF options in that category. You only need one – whichever one that gives you that commoditized thing the cheapest. That's how commodities work. You buy the cheapest one. And technology makes it easy to find the cheapest.
This is why you're seeing an ETF price war erupt between Vanguard, BlackRock, Fidelity, Schwab, and all the other players that are getting in on it. They all know that the DoL fiduciary future means advisers have to do real due diligence. When there's something as commoditized as an ETF for a popular index, technology tools will make sure the best one always floats to the top, and in a commoditized ETF index, "best" usually means "cheapest".
So once everyone uses technology tools to find the one best - cheapest - ETF index in a particular category, the whole landscape changes. In the future for asset managers, it won't just be about trying to get your fair share of the marketplace. This is a winner takes all future. The cheapest solution gets 98% of the flows, the next cheapest gets 2% (for those who investors who failed to find the first), and everyone else gets zero.
That's why the ETF price wars are getting so fierce right now. You're either the cheapest, or you're dead.
The bottom line, though, is simply to recognize that all of this stems from the appearance of the internet, and the technology tools that made it possible for consumers and advisers to be able to easily do real performance benchmarking and real cost analysis for the first time. That's what changed benchmarking from opening statements or looking at the Wall Street Journal, into an actual benchmark comparison of available alternatives. And it was real benchmarking that revealed how many mediocre active funds were out there. Which only got worse as online tools make it easier for consumers to buy those better (often cheaper) funds directly, without paying salespeople.
But it was really the internet started the whole trend. If you go back and look, you'll see that the rise of passive funds almost perfectly coincides with the internet showing up in the mid-1990's. Vanguard had been around 20 years already, but if you look at their growth, it doesn't really start to turn up until the mid-1990's. Because that's when the internet showed up, and suddenly individual investors could easily start buying them directly without middle men.
Then the trend accelerated in 2000. Because through the late 1990's, passive was growing, but active was still growing as well, sinc ewe were in a raging bull market. Nobody really cared what performance benchmarking looked like using those fancy new online internet tools when you could throw a dart at the Wall Street Journal stock pages and make money on anything you hit. It took the bear market showing up. Then, suddenly, investors actually cared about evaluating results. And the combination of a bear market and the availability of tools was the beginning of the end of actively managed mutual funds.
So I hope this is helpful food for thought about the changing active/passive landscape, and perhaps an alternative narrative or way to look at why "now" - or at least, the past 15 years - seems to be the time that passive is dominating active.
This is Office Hours with Michael Kitces, 1:00PM East Coast time on Tuesdays. Thanks for hanging out with us, everyone. Have a good day!
So what do you think? Were there other factors that have driven the rise of passive over active? Why did the shift really begin "just" 20 years ago, and not earlier in the history of Vanguard? Why did it take so long for index funds to really take off? Please share your thoughts in the comments below!
A few years ago, I had a fair number of actively managed funds in a taxable account. It wasn’t easy or cheap, but over the course of three calendar years, I sold or donated all of them, and am invested exclusively in passive index funds.
Interestingly, the internet drove down the prices of term life insurance in a similar manner. When people were more easily able to make apples to apples comparisons, insurers had to lower their prices to attract customers who were able to choose the lowest cost product.
Best,
-Physician on FIRE
Michael,
You make a very interesting point. While I think it’s a combination of the factors you state above, access to the information brought about by the internet is most certainly a major contributor (something I had not really thought about before). It’s a very good point.
I also find your comment about eventually the low cost provider getting all the flows very interesting too. While I think this is true for new money, for those of us who have been indexing for a long time (for myself since the turn of the century) and have significant unrealized capital gains in taxable accounts, we won’t be able to easily shift our investments to the lowest cost provider (assuming we are not already with the lowest cost provider). I suppose we could reinvest dividends in the lower cost option, but with automatic dividend reinvestment I think inertia will likely keep us with the provider we have been using for a long time.
Fortunately I use ishares and their costs are quite low. So should not be a big issue for me. However, others may not be as fortunate.
Mike
Mike,
The near-term effect would simply be the redirection of flows, not the wholesale liquidation of existing positions (not only for tax purposes as you note, but also sheer inertia).
But you can see that happening already. In the past 3 years, active funds saw $250B of outflows, and Vanguard saw $1.3B of inflows. So most of Vanguard’s dollars still aren’t liquidation of other less-favorable funds to buy Vanguard, but Vanguard is capturing the overwhelming majority of all new flows. The wheels appear to already be in motion…
– Michael
Availability of information is the big one. But, I also think back to the 70s and 80s when there were fund superstars like John Templeton and Michael Price getting lots of media attention. Then, along came Peter Lynch, the darling of Money Magazine for years. Where are the superstar managers, today? Of course, on a dollar-weighted basis, most never realized the time-weighted returns, but these three—and a handful of others—were just so difficult to ignore! Now, instead of profiling star managers (that don’t really exist), the media touts index investing.
The public has wakened up to the fleece job that is active management. I think that the public will also wake up to the fleece job that “financial advisor” is. I dare say that now for most upper middle class people their number one cost over a lifetime (after taxes) is “financial advice”. Losing 1% a year is a massive head wind on asset accumulation and serves to transfer wealth from the consumer’s pocket to that of the advisor. Per Democrat operative Gruber the “stupidity of the average American voter” does exist but for how long?
I’ve seen that chart before…maybe during the dot-com era?
It’s not a chart of price, it’s a chart of flows. Very different phenomenon, very different implied outcomes.
Maybe not quite a single winner. When you are talking pure index funds with low single digit expense ratios, it is not trivial to identify the cheapest one. At those levels, differences in how the fund handles stock loan revenue or efficiencies in management that minimize transaction costs could be more important than a couple of basis points in ER. For etf’s one also has to consider spreads, which can vary among funds with identical expenses otherwise. For those with brokerage accounts at one of the big companies, some etf’s trade with no commissions while others have this cost. For a series of smaller trades, these can add up.
I think there could be room for 5 or so giant open end funds or etf’s in each of the major segments.
Freedom,
The underlying nuances like stock loan revenue and execution efficiencies matter. But they’re still something that a computer can analyze and refine to figure out which is “best”.
So strictly speaking, the point isn’t that “the one with the lowest cost will get 100% of the flows” (though cost is clearly one of the biggest driving factors). The point is that “whichever is the best when considering all the relevant factors, which a computer can analyze and point to, will steer 100% of flows to it” because any alternative for an otherwise-commoditized solution would risk being a breach of fiduciary duty.
– Michael
Didn’t the literate world know actively managed funds were a joke after Security Analysis in 1934? Granted the literate population may have been limited in 1934 but surely somebody besides Warren Buffet and John Bogle understood the scam of actively managed funds before the 1990s?
The herd moving towards passive index funds reminds me of an old movie I watched with my kids last weekend, The Incredibles. Syndrome says to the captured Mr. Incredible regarding his superpower, “everyone can be super, and when everyone is super, no one will be”. If everyone buys index funds what will happen to our roller coaster market? If everyone invests the same way, where will the irrational exuberance originate to cause market run-ups and crashes? Will bandwagoning passive index funds by the populous lead to long term market equilibrium? I know what your thinking, “This time its different”.
Tax loss harvesting requires at least two highly-correlated investment options for every asset class, no? Also, failure to recommend the absolute rock-bottom cheapest among comparable ETFs does not constitute breach of fiduciary duty per se. Overall, though, I agree with your point that price competition and economies of scale will tend to reduce the number of competitors offering index funds for the very largest asset classes.
The fiduciary rule alone doesn’t always require the rock-bottom cheapest of comparable solutions, because not every practitioner can be aware of every possible solution.
However, fiduciary due diligence software that analyzes all of them would have a problem if it knowingly recommended an inferior higher-cost alternative with a clear justification why (and the more commoditized ETFs get, the harder it is to find any other distinguishing characteristic). At that point, it forces all flows down to a single ‘best’ provider.
In other words, it’s not a fiduciary duty alone that does this, because a standalone human fiduciary can’t analyze every possibility. It’s a combination of fiduciary duty AND the ability to technology, because technology can actually analyze every investment choice available.
– Michael
Thanks for the clarification, Michael. I’m not a planner myself (just a corporate finance guy with an interest in the subject), so I was not hip to the role of software in supporting large-scale compliance with DoL fiduciary duty.
To my initial point, though, it seems to me that maintaining more than one passive ETF for a given asset class may be appropriate (necessary, in fact) to allow for tax-loss harvesting, which I believe justifies the existence of multiple providers from both a fiduciary and market competition point of view.
I agree that the market for passive ETF’s covering big, well-defined asset classes will end up being dominated by a handful of competitors. I just don’t think it’s going to be winner-take-absolutely-all.
And I also wonder, to the extent that due diligence software relies on algorithmic decisions of the kind you describe, whether it will immunize big planning firms from potential DoL claims as effectively as people might expect.