According to the IMA annual survey, net retail flows into tracker funds went from outflows of £284.4m in 2006 to inflows of more than £1.5bn in 2012. Investment managers are responding by launching more tracker-based funds and a large number of ETFs.
Volatility in stock markets has certainly played its part, although the upsurge in passive sales didn’t really take off until 2010, a full two years after the crisis began.
Historical IMA stats show positive fund flows into indexing during the bear market of 2003, just as it has during the most recent bear market as investors shifted away from disappointing active management.
Of course, cash flows are driven partly by market cycles but, given the strength of the flows, product launches and chatter around the topic, there must be more to it than that. To understand why more and more investors are turning to "passivism", it helps to take a look under the bonnet of investment funds.
Investing is a zero-sum game
Every year, Vanguard updates its research paper, The Case for Indexing, for various markets including the UK. Every year we reach the same conclusion: on average, actively managed funds tend to underperform their benchmarks.
This apparently surprising result makes sense when you think of financial markets as a zero-sum game. All securities combined constitute the very market they trade in. By virtue of containing all these securities according to their market weight, an index represents the average return an investor would have obtained in this market in any given year.
Naturally, only 50 per cent of the securities can perform better than the average whereas 50 per cent must do worse to make the maths work. This simple rule holds for securities markets as a whole and our analysis suggests that it also applies loosely to the universe of active funds.
As a result, even before costs come into play, some investors will invariably find themselves in underperforming funds.
Market efficiency and the number of participants looking at the same securities explain why active managers can struggle to outperform the market. But for a growing number of investors, another factor could be pivotal in tipping the balance in favour of index funds: cost.
Money doesn’t buy performance
Active funds tend to be, on average, more expensive than passive funds. This is because they typically rely on expensive management and research capacities to select securities from the available investment universe.
Tracker funds don’t rely on this analysis and require a much leaner infrastructure to support them.
The success of active management also depends on many factors, including market timing – buying and selling securities at the right time to catch the upswing and avoid the downturn. In our opinion, however, market timing can fail and, even when it succeeds, it incurs transaction costs in the process. Tracker funds only rebalance when the index composition changes, making them usually more cost-efficient.
Management fees and transaction costs reduce the net return investors actually receive from their fund. This shifts the balance in the zero-sum game to investors’ disadvantage. In other words, after costs the number of portfolios underperforming the benchmark exceeds 50 per cent.
The lower-cost structure of index funds gives them an advantage over active funds in the zero-sum game. What is more, this cost effect magnifies through compounding over time, having an ever more tangible effect on investors’ returns the longer their time horizon.
The cash-flows into passive funds indicate that increasing numbers of investors and advisers understand the importance of costs. At the same time, regulatory changes are leading investors to take a new look at their investment objectives and advisers to redefine their service model.
The role of indexing in a new world
Historically, investors have tended to look for the highest possible return and advisers sought to find them the funds that would outperform – a business model that was doomed to fail.
Outperformance is elusive and we have drawn the conclusion that investors often ended up paying excessive fees for disappointing results. Since the recent financial crisis and the changes introduced by RDR, investors and their advisers have moved on.
Asset allocation and long-term planning are gradually taking the place of futile performance chasing. In other words, advisers are focusing on the things they can control.
Our research has shown that investment success depends to a large extent on asset allocation, not security selection.
We see more advisers basing their value proposition on helping their clients build the right portfolio with the right mix of different asset classes and markets. To achieve this, we believe advisers need low-cost, high-value, transparent methods of delivering the broad market return with which to build these portfolios.
Indexing can offer the benefit of transparency and cost-efficiency. Advisers and their clients can decide how they wish to allocate the assets between different markets and simply pick those index funds that deliver the desired exposure.
Indexing, a seemingly unimpressive investment strategy, is a growing trend that is here to stay. We believe that its features are now winning over an increasing number of investors. Active management has its place, but even here we are seeing downward pressure on costs, along with more transparency in charges.
Passive funds may make investing look less exciting, but may also leave investors better off.
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is no indication of future results.