If Index Funds Take Over, Who Else Can Survive?

As index funds approach half of U.S. stock market value, what room is left for actively managed funds and their managers?

Wall Street

We live in the age of the index fund. The only question that remains is whether the actively managed mutual fund industry in the U.S. will continue to stumble forward, or whether it will eventually go the way of the dinosaurs.

Index, or passive, investing has gained popularity for years, as measured by the flow of new investor assets. In a 2017 analysis, Pictet Asset Management projected that, at index funds’ present rate of growth, they could control the entire U.S. stock market by about 2030. While total index domination is unlikely in reality for reasons I’ll discuss later, the projection demonstrates the pace of indexing’s rise. As of February, Morningstar data indicated that index funds hold 48 percent of U.S. stock market assets, and Bloomberg indicated that the figure would top 50 percent by year-end if current trends hold.

The reason for the growth of indexing is hardly a mystery. Index funds are much cheaper than their actively managed counterparts, and actively managed funds have struggled to outperform them in recent years. In most situations, the fees for active management create an extra hurdle that is simply too high for managers to consistently clear. This has certainly been the case in the developed U.S. stock market, although it is not always the case in foreign markets, especially in emerging markets – such as China or India – that suffer from less transparency.

Many actively managed funds have lowered their fees in the past few years in order to remain competitive. According to recent data from Morningstar, the average asset-weighted expense ratio for actively managed U.S. large-cap stock funds has fallen to 0.65 percent, compared to 0.92 percent in 2004. But by and large, active funds struggle to lower their fees far enough to stem the rising tide of indexing. A basis point (one-hundredth of a percentage point) here or there won’t do it, especially as investors become more conscious of how even small differences in fees can add up over time. To go far enough, funds would probably need to cut into profits; the choice isn’t economical.

This trend made me wonder: What would widespread capitulation by active fund managers look like?

Obviously, active management won’t vanish, or even significantly shrink, overnight. As recently as 2017, index investors owned less than 18 percent of the global stock market, according to a BlackRock estimate. And the hedge fund industry, which also represents a form of active investing, boasted a record $3.2 trillion in assets in 2018. But barring a major turnaround in the active management sector, a lot of current actively managed mutual funds are likely to close sooner or later, simply due to market realities.

When that happens, some funds will cash out their remaining investors and close their doors. Other funds on the smaller end may merge into larger funds managed by the same parent company, in order to retain their assets under management. Getting cashed out could lead to unexpected and unwanted tax consequences for investors. Seeing a small fund merge into a larger fund with a different strategy also could frustrate investors, who might feel like the victims of a bait and switch.

If enough actively managed funds disappear, it is not far-fetched to imagine a future where only the major players hold on while almost everyone else succumbs to the indexing wave. There are around 8,000 mutual funds available to investors today; it is not hard to envision that number falling dramatically.

This possibility has its upsides. For one thing, fewer actively managed funds means fewer people will need to manage them. The industry’s overall headcount is likely to decrease as demand for active fund managers falls. It is probably just as well. Young people with keen financial minds can apply their talents elsewhere, rather than spend decades futilely attempting to outperform passive funds.

Investors, too, could benefit if funds that continue to struggle to outperform indexes bow out of the market. They have already benefitted from the downward pressure on fees, for both passive and actively managed funds.

Widespread capitulation would, however, significantly amplify one hazard for investors when evaluating funds: survivorship bias. As actively managed funds close, their histories will disappear – including their historical underperformance. The data that remains could become potentially misleading as a result. In other words, active management as a whole might look artificially strong if only a handful of top funds remain. Data providers would need to take steps to make sure investors properly understand this so that they can make decisions with a clear-eyed view of the historical data.

Some observers have expressed concern that a greater proportion of passive investing to active investing could create distortions in the market. By their nature, index funds don’t set prices for securities. Instead, they accept existing prices, set by active investors. If no active investors at all remained, there would be no one to determine securities’ real value.

As I have written previously, I find it unlikely that passive management could become so dominant that it would create a situation in which securities became massively mispriced. If nothing else, markets tending in a less efficient direction would create an incentive for the remaining active managers to seize the opportunity to outperform their benchmarks. In a world with fewer active funds, the fund managers who remain will likely be skilled and experienced, and they will not pass up such opportunities. Martijn Cremers, a dean and professor of finance at the University of Notre Dame, recently argued in The Wall Street Journal that fewer active managers means more opportunities for those who remain to identify mispriced securities, and thus preserve a smaller actively managed fund sector’s value to investors.

On the other hand, a scenario where only the best of the best are managing mutual funds might present an even more challenging environment for active managers than today’s market. In order to take advantage of a perceived mispricing, a fund manager has to find someone willing to sell that security at a price below its intrinsic value. Index funds trade infrequently compared to their actively traded counterparts, so as the actively managed fund market shrinks, remaining managers may find it harder to find sellers who will sell securities at a discount compared to their perceived value.

In my view, active mutual fund management will always survive in some form or fashion in the United States, because some investors simply cannot resist the allure of trying to outperform the market. Even if major capitulation arrives, there will always be less-efficient corners of the global market where active managers can add value. But imagining a world where actively managed funds are reduced down to a handful, to the benefit of young professionals and investors alike, is getting easier all the time.

About Paul Jacobs 13 Articles

Affiliation: Palisades Hudson Financial Group

Paul Jacobs, CFP®, EA, joined Palisades Hudson as an associate in Scarsdale in 2002. In 2006 he became a client service manager and transferred to Fort Lauderdale. In 2008 Paul moved to Atlanta, where he is presently the client service manager in charge, to establish the firm’s office there.

As chief investment officer and chairman of the firm’s investment committee, Paul directs a team of portfolio managers and associates focused on finding the most efficient and cost-effective ways to implement client portfolio strategies. He oversees more than $1 billion in client assets, including all aspects of investment strategy, portfolio management, due diligence, and manager selection.

Paul formerly served as the firm’s Chief Compliance Officer, and he has had extensive experience in the firm’s investment management and tax compliance practices. His additional responsibilities include developing and monitoring client portfolios, reviewing tax strategies and returns for clients, and developing comprehensive personal financial plans. He also has worked on client projects involving charitable planning, bookkeeping, retirement planning, and estate planning and administration.

Paul graduated from New York University’s Stern School of Business with degrees in finance and accounting. He is a CERTIFIED FINANCIAL PLANNER® certificant, an Enrolled Agent and a member of the Financial Planning Association of Georgia.

Paul is the author or co-author of numerous Sentinel articles, including “Pay As You Go: Tax Rules Upon Expatriation” (June 2012), “Beware Mutual Funds Using Hedge Fund Strategies” (January 2012), “Is There A Bubble In The Bond Market?” (October 2010), “Should You Do A Roth IRA Conversion?” (February 2010), and “Private Equity In A Deleveraged World” (April 2009).

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