More than nine years into a bull market in equities - a long stretch by historical standards - a drumbeat of noise is rising about whether the “passive” approach to managing money is reaching a peak and becoming a source of future trouble.

Although wealth industry practitioners dislike the term, “passive” is broadly useful in meaning an investment that involves tracking some kind of index rather than picking and choosing individual securities in order to outperform a market to capture "Alpha". The case for passive rests on the notion that most modern financial markets are efficient and discount available information, and that opportunities to capture market-beating Alpha aren’t as great as supposed, and that paying for such Alpha is seldom worth the money. These are big claims, of course, and some markets are more liquid and efficient than others, which is why the active/passive debate is an endless one. 

Even so, with regulatory costs rising, it is easy to see why wealth managers have embraced cheap index-tracker entities such as exchange-traded funds. ETFs break records for assets under management every month with monotonous regularity. At the end of April, ETFs and exchange-traded products held more than $4 trillion in AuM (source: ETFGI). To put those figures into context, the total value of the global stock market was around $65 trillion last year (source: World Bank); that number has increased since. ETFs still make up around 6 per cent of the total stock market, so there may be further room for growth yet. The growing use of ETFs has squeezed fees: firms such as and others have said for some time that asset management increasingly resembles a “barbell” shape, with one end dominated by low-cost, index-tracker businesses where economies of scale dominate, and the other end of the “bar” is full of high-fee alternative, Alpha-chasing areas such as hedge funds, private equity and private credit. The people in the middle get squeezed out. Arguably the same trend can be seen in other fields: mass markets at one end; niche, high-end services/products at the other.

The rise of passive is understandable for a number of reasons, therefore, but does the growth of passive investing bring new risks? One issue is that if actively-managed funds become less significant, the price of a company’s stock will say less about what investors think about the nuts and bolts of a company and its management, and instead only reflect broad-based investor sentiment, driven by forces such as central banks' interest rates. It is also harder for activist-minded fund managers to make a difference if everyone is “going passive”. Arguably, such passive investing also further divorces the end-investor from the underlying companies that generate earnings and capital growth, making the capitalist system even more remote from those supposed to benefit from it. (At a time when political populism and hostility to free markets is on the rise, this aspect of passive investment is more significant than many may realise.)

Another argument, made in early May by the ,” he said. To some extent, he said, the trend of “factor-based investing” or Smart Beta, in which indices are composed of securities that exhibit certain characteristics (yield, value, momentum, etc), shows that there is a move towards a more sophisticated idea of what index-based investing should involve.
The Smart Beta approach has developed considerably, he said.

Another organisation, Barings, argues that passive investing simply doesn't work well in certain areas, such as high-yield securities. In a recent note, the firm said: "The often-touted fact that the 'average' active manager routinely underperforms the index has encouraged investors to embrace passive investing over the last decade. In many asset classes, like large-cap US equities, this has proven to be a lucrative strategy. Investors gain exposure to an underlying asset class while incurring much lower costs. The problem, of course, is that this 'one size fits all' passive investment strategy does not work equally well across all asset classes. Fixed income markets are a good case in point, particularly the high yield bond and senior secured loan markets."

Explaining why high-yield debt is problematic for the passive approach, it continued: "Fixed income’s more limited capital appreciation potential means investors stand to lose significantly more than they may gain on any given bond - so avoiding 'losers' is critical for success. However, that’s harder for ETFs to do, since their investment decisions are flow- and rules-based as opposed to value-based. Active managers of high yield, on the other hand, are not restricted to any reduced 'list' of issuers, and can exercise greater flexibility on when to trade."

Tough to be active
There is no doubt that recent years have seen active management come under pressure. US actively managed funds, for example, suffered net outflows of $340 billion in 2016, while passive vehicles took in $505 billion (source: Financial Times, Morningstar, Bernstein). In specialized areas such as hedge funds, there have been grumbles for some time about the 2 per cent and 20 per cent annual management fee/performance fee model, with modest returns adding to the ire. One of the legends of investment, Warren Buffett, fanned the flames in favour of passive investing in his annual letter to shareholders, saying index-tracking funds were a better long-term bet than hedge funds were. 

Another reason why passive investments might be gaining ground is that regulations encourage advisors to avoid risk of being sued or fined for unsuitable advice. It is harder, arguably, to get into trouble by recommending a tracker fund for the S&P 500 or the FTSE 100 than it is to recommend a private equity fund or suchlike. It could well be that passive is part of a sort of “precautionary principle” mind-set that has taken hold of investment professionals since the traumas of 2008. 

As wealth managers should realize, however, players in financial markets can make the same error as old generals who fight the war that has just happened, rather than those yet to come. The rise of passive investing has been impressive, full of genuinely smart innovation and meeting the need for lower costs. The issue, as ever, is whether the drive towards passive investing might not be as tranquil as it sounds if, or when, market conditions change.