Sarah Ketterer
Over the past two decades, passive investing has ballooned as retail and institutional investors alike increasingly move their money out of more expensive actively managed strategies and into cheaper, passively managed index funds.
The rise of passive investing has seemingly been a no-brainer: It's cheaper and historically more successful than its active counterpart.
Though it's hard to know exactly how big the passive investing snowball has gotten — estimates from the past couple of years range from 16% to 38% to more than 50% of the U.S. equities market — it's universally agreed that passive investing's market share is only getting bigger.
"Passive (investing) is like a snowball, it just keeps picking up more snow as it rolls down the hill," said Sarah Ketterer, CEO of Causeway Capital Management, which had $42.2 billion in assets under management as of Sept. 30.
The trend toward passive investing has made active investors into the underdogs. Their fees are considerably higher: Average fees for passively managed index mutual funds were 0.05% in 2022, while actively managed mutual funds charged an average of 0.66%, according to the Investment Company Institute's 2022 fee report.
Active investors have argued that the success of their passive counterparts is largely tied to the era of easy money with very low interest rates following the 2008 financial crisis. Low rates propped up unprofitable companies, and valuations for assets from technology stocks to real estate also surged, while index funds caused industry stocks to rise and fall in unison, rather than on their individual merit, sources said.
With the Federal Reserve significantly raising interest rates the past two years amid surging inflation, there are signs markets are shifting to favor active investors.
"We're in a different interest rate era and a different monetary policy era — one of shrinking central bank balance sheets and less liquidity," Ketterer said. "And it's just started. The effects of rate rises take 18 to 24 months from when they first begin. So we're only 18 months from the first rate rise, and the U.S. began before the other developed markets. So in a year from now, this could be even more fascinating." Ketterer's firm, Causeway Capital, is an active manager focused largely on international equities.
In its U.S. Active/Passive Barometer midyear report published in June, Morningstar found that more than half (57%) of actively managed mutual funds and exchange-traded funds outperformed their passive counterparts between June 2022 and June 2023, up from 43% in 2022.
The success of active managers was seen across the board. Even active large-cap managers tended to beat their passive counterparts (53%) from June 2022 to June 2023, a notoriously difficult sector for active managers trying to top the market. Active small-cap managers (65% beat their passive competitors) and active international equity traders (63%) had even better success.
Despite their 2022 turnaround, active managers' long-term track record still pales in comparison to their passive counterparts' over the past decade: According to Morningstar's report, just a quarter of active strategies survived and beat their average passive counterpart between June 2013 and June 2023. Success rates were higher on average for actively managed foreign stock, real estate and bond funds, and lowest for U.S. large-cap strategies.
Active managers like Graeme Forster, director and portfolio manager at Bermuda-based Orbis Investment Management, have hailed the recent change of fortunes for active investors as a sign that the pendulum is swinging back.
Forster said the prolonged period of growth caused by an everything bubble had made active management a tough sell.
"Active managers get killed when buying becomes indiscriminate," Forster said. "(Clients) look at active managers and say 'What am I paying these fees for?'"
Those fees, active managers argue, pay for a lot. In addition to attempting to beat the markets for their clients, active managers, including Forster, argue that they serve as a sort of financial watchdog.
"You need active managers to drive rational pricing, which ultimately leads to improved capital efficiency across the economy and greater wealth for everyone," Forster said. "The (growth of passive investing) has gotten to the stage now where it's arguably becoming counterproductive … as a large portion of investors have little cognizance for the true value of what they own." Orbis had $34 billion in AUM as of June 30.
Over the past 15 to 20 years, interest rates have been at "zero, or thereabouts," said Barry Mandinach, executive vice president and head of distribution at Virtus Investment Partners. Now that interest rates have normalized in the 5% range, he argues that the strength of a company's balance sheet and quality of their earnings will suddenly matter a lot more.
"Sure, in the last 15 years, you could not have set a better stage for passive investing because the rising tide was lifting all boats. And if the rising tide is lifting all boats, and you can get on one boat for free, and another boat costs money to get on, why would you pay money to get on the boat?" he added. As of Sept. 30, Virtus had $162.5 billion in AUM.
Active managers like Forster have described the march toward passive investing as a tragedy of the commons – "Low-cost passive investing began as a public good, but it has perhaps reached the point where insufficient price discovery becomes negative for society as a whole," Mandinach said.
Forster and his fellow active managers are not alone in voicing concern that the rise of passive investing could negatively impact the health of the financial markets — the discussion is a common one among industry participants, academics, journalists and financial regulators alike.
Passive investing's detractors are concerned that indexing has put the economy on autopilot, reducing competition and allowing big companies to get even bigger, sucking more money into their ever-larger gravitational pull without necessarily staying inventive, good or even profitable.
"What is passive investing, really? You're valuation agnostic, you're quality agnostic, you're strength-of-balance-sheet agnostic," Mandinach said. "If it's a fixed-income passive investment, you're credit worthy agnostic?"
Beyond worries about market stability, critics of passive investing are also concerned that its growth has led to a sort of financial oligarchy in which large asset managers like Vanguard Group, BlackRock and State Street Global Advisors are the largest shareholders in many of the largest publicly traded U.S. companies.
Even Jack Bogle, the founder of Vanguard and the father of index investing, expressed concerns in a Wall Street Journal op-ed published two months before his death in early 2019 that passive investing had potentially grown too big for its own good.
"It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the 'Big Three' might own 30% or more of the U.S. stock market — effective control," Bogle wrote. "I do not believe that such concentration would serve the national interest."
Vanguard declined to comment on the point Bogle raised in his op-ed, and instead pointed out the well-documented benefits for passive investors.
"Many broadly diversified index funds have very low expense ratios, which enables investors to keep more of the returns earned by their funds — and those savings can compound over the long term to make a meaningful impact on investors' ability to meet their goals," said Dan Reyes, Vanguard's global head of portfolio review department. "As Vanguard founder John C. Bogle often said, 'in investing, you get what you don't pay for.'"
Reyes added that indexing also benefits from low tracking error: "Some actively managed funds, on the other hand, can have periods of tremendous outperformance followed by periods of painful underperformance. Too many investors chase returns and invest in a fund after its period of outperformance, then abandon the fund near its lows following its underperformance — a buy high, sell low strategy that is doomed to fail," Reyes said. "The relative predictability of index funds can help some investors stay on track through the ups and downs of the market."
Reyes also rejected the idea that the growth of passive investing was messing with stock prices. "One thing that's important to keep in mind about index funds is that they're the ultimate buy-and-hold investors. So index funds generally have only modest effects on the markets because they trade so infrequently. In fact, Vanguard estimates that indexing accounts for less than 5% of all trading in the stock market. Trading by active managers is more than sufficient to enable efficient price discovery in the markets," Reyes said.
The "Big Three" managers — BlackRock, Vanguard and State Street — have come under fire for the sheer size of their passive investing products. The three firms held a collective 22% stake in S&P 500 companies at the end of 2021, and represented a quarter of the votes cast at annual meetings of those companies. For 90% of those S&P 500 companies, one of the Big Three is the largest shareholder.
Activists and politicians alike have pushed back against the growing dominance the three firms have in the market, but BlackRock in particular has become a lightning rod for the criticism.
BlackRock, the largest asset manager in the world with $9.1 trillion in assets under management, has large active and passive businesses. But the firm's meteoric rise to the top is inextricably tied to the growth of its passive iShares ETF business, which it acquired in 2009 from Barclays Global Investors.
BlackRock's growing influence has made it a particular target for politicians and activists on both sides of the political spectrum as CEO Larry Fink's embrace of ESG investing put the firm in the crosshairs of Republican politicians, who have argued that ESG investing unfairly hurts the energy industry.
Meanwhile, climate activists, too, have blasted BlackRock for not being aggressive enough in pushing companies to meet climate goals, heckling firm executives at public events and protesting at BlackRock offices.
The blowback has led to changes at BlackRock: last year, the company started paying for round-the-clock security for Fink and Rob Kapito, president and director of BlackRock. Fink has also attempted to wash his hands of the souring ESG discourse, saying in June that he would no longer use the term ESG because it had become "totally weaponized."
BlackRock has also been expanding its voting choice program, which allows select clients to vote their own shares, to a broader slice of investors. Other firms, too, have followed in BlackRock's footsteps, offering their clients the opportunity to vote their own shares.
Though BlackRock's passive products have had the spotlight for the past decade, there are signs that the firm's actively managed funds are having a renaissance as BlackRock tries to burnish its reputation as more than just a passive manager.
The firm has been at the forefront of lowering fees for its customers of both active and passively managed strategies.
Speaking at a Semafor event in New York on Oct. 3, BlackRock senior managing director Mark Wiedman, who is also the firm's head of international and corporate strategy, said he believes the conversation has "moved on from active vs. passive" and is now about price compression and value for money for customers.
"Yes, of course, you're seeing the continued growth of index equities, for example, and index fixed income, but the really big impact has actually been on price competition on active mandates, in a world that didn't even have price competition 10 years ago," Wiedman said. "Basically, customers are saying 'In a world where money costs something, I want you to really show your value for money. And if you're really good, I'll pay you. And if you can't prove to me you're really good, I really need you to knock the price down dramatically.'"
