In 1974, economist Paul Samuelson published an article arguing that the majority of mutual funds should go out of business, calling instead for low-cost alternatives to the expensive actively managed funds which were consistently underperforming.
One year later, Vanguard founder Jack Bogle set up the first index fund which was initially met with disappointing inflows and hostility from the industry, with some denouncing it as ‘Marxist’ and ‘un-American’.
However, 45 years on, Vanguard’s first-mover advantage in the passive space has helped position it as the second largest asset manager in the world behind BlackRock.
While criticism of passive funds is far less hostile today, there are some that take issue with their influence on markets.
In a letter to the FT in November, Aberdeen Standard Investment’s Harry Nimmo described passive funds as “parasitical”, on the basis that “they do not participate in equity fundraising and are indifferent to the relative merits of individual equity investments”.
With that in mind, Trustnet spoke to a cross-section of market commentators for their views on whether passive funds are truly ‘parasitical’ or whether they have a role to play in capital markets.
Efficiency of capital allocation
Expanding on his comments to Trustnet, FE fundinfo Alpha Manager Nimmo argued that passive vehicles have no direct participation in capital allocation, something he describes as one of the key functions the stock market.
“They never meet companies,” he said. “They’re indifferent to whether an idea is worth investing in and therefore are not part of the capital raising equation.”
However, Jan-Carl Plagge, senior investment strategist at Vanguard, argued that the failure of active managers to beat their prospective benchmarks is a far greater inefficiency than the allocation of capital.
“Index investing is actually the most efficient way to invest,” said Plagge. “The index investor is allocating capital in accordance with the aggregate consensus.”
He said active management is a deliberate deviation from the market aggregate as it is based on someone’s perspective.
Passive advocate Robin Powell of The Evidence-Based Investor agreed with Plagge, adding that deviation from the market aggregate can be bad for individual investors.
“Over meaningful time periods, index funds provide far better returns for investors than the vast majority of active funds,” said Powell.
“Yes, asset management is partly about efficient capital allocation. But surely from the consumer’s point of view, it’s also about generating good returns for investors?”
Supporting companies through equity fundraising
On equity fundraising, Nimmo’s said capital should be raised to support companies through difficult periods – something that has been especially relevant this year as the Covid-19 pandemic has taken a toll.
“Considering all of the businesses which had to close during lockdown,” started Nimmo. “Yes, there was government help, but the stock markets are there to play their part.”
He explained that an active manager has the choice whether to support that businesses through a bumpy period, unlike managers of passive funds.
However, The Evidence-Based Investor’s Powell said it was the presence of passive funds that were essential in stabilising the market after the downturn in March.
“Equity fundraising is important, but it’s not as if active managers are doing it as a public service,” said Powell.
“During the sell-off, indexers carried on holding – and indeed buying stocks, helping to provide liquidity while active investors were heading for the hills.”
Fostering growth through equity fundraising
Nimmo’s second position on equity fundraising is that passive funds do not directly participate in the growth of small- and medium-sized companies, where he specialises.
“There is a responsibility of the stock market to develop its smaller businesses to create wealth and employment,” said Nimmo.
He highlighted the Alternative Investment Market (AIM), the junior market of the London Stock Exchange which has historically helped smaller companies access capital from the public market to fuel growth.
According to Numis Securities, roughly $13bn has been raised by UK AIM-listed, small and mid-cap companies so far this year.
“Passives are not doing anything to support fundraising in the AIM because the stocks are not in any popular indices,” he explained.
Vanguard’s Plagge argued that while passive funds have a smaller portion allocated to small-cap stocks, this is more to do with market capitalisation rather than those stocks being overlooked.
“Passive strategies allocate funds in accordance with the capitalisation of those stocks,” said Plagge. “Small-caps are less capitalised by definition, so it’s not the case they are underweight smaller companies.”
From an indexing standpoint, Plagge also argued that by investing in indices representing different segments of the market, an investor can build quite an active exposure to smaller companies through niche index funds.
‘Parasitical’
The kind of labels for passive strategies bandied about in 1975, such as ‘Marxist’ and ‘un-American’, have since been replaced by sentiments such as ‘anti-capitalist’ and by Nimmo “parasitical”.
“It feels to me that passive funds in many ways are bad for the economic health of liberal capitalist stock markets,” said Nimmo. “They are essentially parasitical – the stock market exists and they’re piggy backing the existing structures.”
The Evidence-Based Investor’s Powell said he believes this comment to be hypocritical in the extreme.
“It’s a classic case of the pot calling the kettle black,” he said. “The UK fund industry has gorged itself on the savings of the nation for decades, charging far too much and providing negative value in return.”
Powell said indexing allows consumers to invest in “far more stocks, far more efficiently and far more cheaply” adding that it is “the very essence of capitalism”.
Vanguard’s Plagge echoed this and argued that the benefit to individual investors comes from offering broadly diversified exposure to markets at a very low cost.
“The alternative is often for investors to have a more concentrated portfolio, which can bear significant idiosyncratic risks,” said Plagge.
Despite 45 years between the launch of Bogle’s first index fund and today, however, it may be surprising to note that it’s not the first time that passive strategies have been labelled “parasitic”.
Indeed, in a letter to the Wall Street Journal in 1975, Edwin A Zeuschner of Chase Investors said index funds, “take advantage of the efficient market created by all other investors, and in this sense, is parasitic”.