Consequences of passive investment

Miguel Cantera: conseqüències de la inversió passiva

Passive funds (both ETFs and index mutual funds) are collective investment vehicles which, by following certain rules, seek to obtain a return as similar as possible to an index (the best-known being the S&P 500, Ibex 35, MSCI World, etc.) by investing in the same assets with the same weights. The main advantage of these kinds of funds is that they entail a much lower cost for the investor than active funds, as they require very little (if any) management.
The first passive fund, the Vanguard 500 Index Fund, was created by John Bogle (the founder of the Vanguard Group) in 1976 and it’s still one of the most popular passive funds today. For years, these funds weren’t particularly well-regarded, as they were often criticised for simply attempting to achieve the index’s performance without surpassing it, contrary to what popular investors like Warren Buffet were doing. This view has changed significantly since the great global financial crisis of 2008; in an environment of low interest rates and growth, investors have given much more importance to the fees charged for their investments. Nor can we deny the fact that the vast majority of active funds are unable to outdo the benchmark index over long periods; this factor, which had been overlooked for many years due to the high pace of growth, has become extremely relevant in this new environment and has benefited index funds, which are becoming more and more popular and gaining ground on active funds. Passive strategies currently account for a large proportion of the market. In the United States, passive funds and ETFs now account for more than 40% of combined active and passive investment and, in particular, in the case of equities, the proportion rises to over 48%.

There couldn’t be any passive funds or ETFs without the creation of indices. In the past, the indices had a purely informative purpose and the decisions regarding the inclusions and exclusions made by the providers had only a certain degree of influence on active funds, but the growth of passive investment means that these decisions now have a much greater effect. Nowadays, changes in the index entail significant resource movements in or outside the major indices, leading to flows amounting to billions of dollars. As a result, these providers have become some of the main players in the market, given that, in a way, everyone who invests in a passive fund or ETF delegates the investment decisions to the committees of the indices, which sometimes enjoy a large margin of discretion when it comes to deciding which companies enter or exit them. In 2020, news broke that, for the first time, a worker for a well-known index provider had been arrested by the SEC (the American regulator), accused of using inside information on the companies that were to be included and excluded from the index. The case is currently being investigated by the US authorities.

The advantages of investing in passive funds are clear; the low fees and the excellent returns over long periods make these investments ideal for passive investors with long time frames. In historical terms, the drawbacks of investing in these funds were their vulnerability to market crashes (active funds tend to perform better during these crises) due to their lack of flexibility and the loss of what is known as alpha or the ability of some managers to generate consistent performances above those of the market. In recent years, new disadvantages have emerged that all investors should bear in mind when they invest in passive funds or ETFs. Historically, indices such as the S&P 500, MSCI Emerging Markets and MSCI World have been synonymous with diversification, but the way in which most indices are constructed (weight in keeping with market capitalisation) and the major growth of passive investment and certain companies, regions and sectors have meant that, for example, the weight of the five major technological companies in the S&P 500 doubled from 11% in 2014 to 22% in 2020, while the weight of the last 300 companies has fallen from 20% to the current level of 15%. In the MSCI World, the weight of American companies accounts for 66% of the index, while in the MSCI Emerging Markets the weight in China has increased from 18% in 2014 to the current level of 40%. This concentration only intensifies as passive investment increases, as the way in which most of the indices are constructed means that the weights of the larger companies go up as passive investment increases: it’s a vicious circle. These considerations have to be taken into account when it comes to building portfolios, but passive investment is just another tool and it shouldn’t represent the bulk of them. This trend towards passive investment provides great opportunities, particularly for mid and low-capitalisation companies, which get left behind, not because they aren’t good companies but simply because of a lack of passive flows. These shortcomings can only be remedied by active managers, who are becoming increasingly rare in the market.

 

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