Actively-managed funds are a dying breed, in part because so many people are seeing economic value in passive indexes.
One can simply buy a broad market index fund and enjoy the returns of the entire stock market while paying a paltry fee of only a few basis points each year.
Growing skill gaps
When mutual funds die, or simply make up less of the assets under management, there will be an enormous skill gap.
Right now, a few different types of market participants drive prices:
- Active individual investors
- Active mutual fund managers
- Active hedge fund managers and activist funds
Passive funds piggyback the valuations put in place by these three market participants, so their input on “pricing-in” new information is…well, just about zero.
To be sure, the overwhelming amount of capital is still invested in active funds, particularly actively-managed mutual funds, which are accessible for small time retirement savers and everyday investors. Many do practically nothing for the investor, seeing as they’re really just closet indexers who actively manage only a small part of their portfolio. A much smaller share is managed by hedge funds (accessible only for those who meet requirements for accredited investors.)
Supposing that actively-managed mutual funds make up a much smaller share of assets under management in the future, stock prices will be dictated only by active individual investors (including those who take stock tips from cocktail parties) and active hedge fund managers, who manage funds on behalf of the super-wealthy investor class.
Imagine a world in which the retail investor and hedge fund managers are the only investor classes with any real input to a security’s value. Remember, passive funds buy stocks based on an algorithm, usually by market cap, basically hoping to latch on to the collective wisdom of all active participants in the market.
If in the future substantially all market activity is driven by at-home investors and hedge fund managers, who can really only work for the top 5% of income earners or households by net worth, there are only two real outcomes:
- Stocks become more frequently mispriced, as their market prices are more greatly determined by people who have no idea what they’re doing (retail investors with no background in finance in any way, shape, or form.)
- A growing wealth gap, as hedge fund managers who can only work for the wealthiest investors enjoy the ability to correct mispricing that comes from retail investors and passive funds
Where’s the equilibrium?
Suppose that 80% of all investment capital is passively invested and simply chases the 20% that is actively-managed. Said another way, one-fifth of assets will be used to actively seek new values. The remaining 80% will be invested in “me too” funds, funds that follow what everyone else is doing.
Imagine what this reality would look like. Fewer people would have much more input on the valuation of any given security. The power to value companies would be vested entirely in hedge fund managers and, to a lesser extent because they have less capital, retail investors. These valuations set by an elite club of fund managers and retail investors would be indiscriminately accepted by passive funds, which merely want to track the entire market.
I’m not sure where this equilibrium is. Passive funds are finding more and more AUM by the day. In 2011 alone, twice as much new money was invested in ETFs than was invested in actively-managed mutual funds. Eventually, passive funds could make up half or more of all assets under management, squeezing out mutual fund managers on the margin of profitability and vesting more power into the few remaining players – retail and hedge fund/activist investors.
If I had to make a prediction…
Asset allocation isn’t going away any time soon. However, I do think that its advantages will wear out at some point over the next 10 to 20 years.
In that time, we’ll see active funds die and asset allocation take over. And during that period, I think we’ll see ever-growing returns for activists, who will correct public company mispricing with take-private bids.
There’s an inflection point to be found somewhere. You simply cannot have a market that is entirely driven by passive funds. Where that inflection point is, I’m not exactly sure. But we’ll probably overshoot it before we shoot under it. I still think passive funds have trillions of dollars of growth ahead of them before active management makes sense once again. In the meantime, I expect historical outperformance from activist funds only to continue, and the margin for outperformance to grow over the next 10-20 years.