The rise and rise of passive investing!
Big shout out to Prof. Javier Estrada from IESE Business School's Wealth Management class for not only introducing me to this side of investing but also convincing me for it with pure data.
The debate over the merits and shortcomings of active and passive investing has been borne into the minds of all for a long time. What kind of investment to make at different points from the viewpoint of market returns has been a long-standing dilemma. To address this dilemma, we must start by understanding what these methods of investment actually mean.
Active investing is a term we come fairly across while reading about the markets. These kinds of investments are usually made with the objective of outperforming the market and making short-term gains. They involve fast trading and depend on the volatility of the market. While these are the investments people generally opt for, there is a trend of passive investing coming on the stage for a few years now.?
Passive investing, put in simple terms, is just a buy and hold strategy, with investors not engaging in the market once their portfolios are made. Such investors aim for a diversified portfolio - representative of the trends usually tied to the market. The basic goal of investors going for this strategy is - wealth creation obviously but, based on the fact that given enough time, the market will give positive returns, and thus do not try to trump the market, as active investing tried to do, instead, replicate it.
The image below gives a clean overview of the kinds of investments available today and which bucket it falls under:?
Overview
?The 2021 report by Finity estimates the share of active assets under management (AUM) in the overall assets of the Indian mutual fund industry will fall from 90% as of March 2021 to 63% in 4 years.??The same report estimates the AUM of passive funds to cross $332 bn by March 2025 from $39.88 bn in March 2021. It estimates that the
share of passive AUM in the overall assets of the Indian mutual fund industry will surge from 10% as of March 2021 to 37% in March 2025.
According to the BCG Global Asset Management Report 2021, most traditional asset classes generated double-digit growth in 2020, outstripping their historical five and ten year averages.
Meanwhile, a report by BCG on the global asset mix of mutual funds showed that the AUM of passive funds was pegged at $22 trillion in 2020, which is expected to rise to $34 trillion in 2025. Interestingly, passive products recorded their highest growth in the pandemic-affected year as the AUM rose 17% globally. Both equity ETFs and fixed-income ETFs beat their ten-year average growth rates, capturing AUM growth of 21% and 24%, respectively. Non-ETF passive offerings also performed well.
BCG expects passive investments to be the fastest-growing asset class over the next five years, expanding by 9% annually.
Passive vs Active Investing
To get a proper idea of sustained investment type over longer periods, a two-phase analysis has been elucidated - inter-temporal and across business cycles.
Under this, we aim to weigh up the costs and benefits of active and passive forms through different time periods. The time periods of interest here are - short-term investments, of 1 year, medium-term, of 3-5 years, and long-term, above 5 years.
In the short run, active funds are seen to outperform passive funds, which are made with the aim of long-term investment. With active investing, portfolio managers and investors aren’t required to hold certain stocks and bonds, which means they not only have a wider opportunity set to select from, but they can also benefit from short-term trading opportunities. This option is not available with passive funds.
Looking at medium-run investments, passive funds have a slight edge. This is because they are transparent meaning investors typically know which stocks or bonds are held in an indexed investment. Also, these are tax efficient as most index funds do not trigger a large annual capital gains tax because they do not trade often.?
In India, trailing returns data shows that on average, over 70% equity mutual funds have underperformed their benchmarks in the five-year period.
If one looks at long-term records of managers in evolved global markets, there are very few active managers who have been able to outperform the benchmark returns. Even after a lot of research, higher costs, and relative difficulties of fund selection, active managers are unable to outperform the benchmarks. In such a scenario, it is obvious that most investors prefer to have a higher allocation to passive funds rather than to funds that are actively managed.
The easiest way to see whether actively managed funds have outperformed their benchmarks is to compare returns vis-à-vis benchmarks on any given day. See the table below. As per this comparison, a meager 29% of the schemes have been able to beat their benchmarks over the long term. A maximum of 41% (not even half) have been able to beat benchmarks over the medium term.?
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2. Business Cycle Analysis
During a recession, stock prices frequently fall. Though this is bad news for a current portfolio, leaving investments alone means not selling to lock in recession-related losses. During a recession, people may think you're buying at a low, only to see the portfolio value decline a few days later. The best way to avoid losses in a recession is to take a long-term approach to invest. This way if properly planned, the portfolio can make huge gains in the future. This proves that passive investing is the optimal choice to go with if investing during a recession. Active funds are probable to make losses, as the market crashes. Look at some US-based examples:
Boom is associated with rising stock prices, and full-fledged trading occurring in the market. During these periods it is advised to take on active investing rather than going passive. If funds are chosen correctly in the boom period, their prices will rise, thus bringing the investor profits. In these periods passive funds are not recommended as they tend to give low rates of interest, compared to the active funds. traders, thus, bend towards high-interest paying, and actively trading stocks.
Ultimately, it boils down to cost.
It is important to note that there are costs involved with trading. It may not sound alarming when compared to the size of the investment, but similar to returns, costs also compound over the years. Below is a small example of how costs balloon and should become an important criteria for fund selection.?
As the Nobel-winning economist Professor William Sharpe pointed out in his paper The Arithmetic of Active Management,
the average passive investor must — yes, must — outperform the average active investor, because of the considerable additional costs that active investing entails.
The cost of using the active funds will put a huge drag on your investment performance which any fund manager would struggle to overcome through stock selection or market timing.
Passively managed large-cap funds charge an expense ratio of 0.05-1.11 percent whereas the expense ratio in actively managed large-cap schemes can be as high as 2.72 percent, shows data by Value Research.
The expense ratio is the annual maintenance charge levied by mutual funds to finance their expenses. It includes annual operating costs such as management fees, allocation charges, and advertising costs of the fund.
CEM Benchmarking, a Toronto investment consultancy, compared the returns from hedge funds reported by 150 large institutional investors with simple benchmarks that combined equity and debt indices. These blended benchmarks were designed to match the risk profile of each hedge fund. CEM found that even though hedge funds delivered an average of 145bp of outperformance annually, they however underperformed the simple benchmarks by an average of 127 basis points annually between 2000 and 2016 after fees were taken into account. High fees destroyed the superior returns that hedge fund managers produced.?
Conclusion
The ultimate question that arises after the discussion above is what types of funds should a common person choose? The answer is not so black and white but lies somewhere in the middle. Firstly, it depends largely on the following parameters:?
When the market is volatile or the economy is weakening, active managers may outperform more often than when it is not. Conversely, when specific securities within the market are moving in unison or equity valuations are more uniform, passive strategies may be the better way to go. Depending on the opportunity in different sectors of the capital markets, investors may be able to benefit from mixing both passive and active strategies—the best of both worlds, if you will—in a way that leverages these insights.?
Slow and steady wins the race. This is probably one of the best ways to describe what is famously known as - “Passive Investing” in today’s financial terms.
These funds are on the rise not just globally but also in India, people have started accepting the fact that minimal trading yields maximum returns. The most appropriate option at this point in time would be to have a diverse portfolio, customized to suit an individual’s risk-return analysis.
Works Cited
MBA London Business School | President Consulting Club | Strategy HyperSpace | Chartered Accountant | Automotive Enthusiast
2 年Really impactful read, right amount of detail as well!