Index Funds Will Put Active Asset Managers out of Business

There are two strong, differing theories about the future of investment management. One comes out of the journalist community with one reporter wanting to know why the position of active asset manager still exists. Slots for these positions grow, even with the market aware they’re meaningless, bringing nothing to the table. This is grounded in the idea that passive investors let fund managers charge fees for the privilege of trying to outpace the market. The hopelessness of this endeavor was obvious during the 2008–2009 financial fall where these so-called financial experts had no more influence than anyone else avoiding loss.

Curiously, updated statistics indicate over 75 percent of new sales are still going to active funds and that somewhere in the vicinity of $2 trillion a year goes into that industry annually. Despite a tepid performance, hedge funds achieved an astonishing $2.7 trillion record in management.The other theory comes from the chief investment officer at Allianz Global Investors. Andreas Utermann insists any growth seen in passive indexers has provided an opportunity for active managers to do great things. Unfortunately, the facts don’t jibe. Stock markets are currently considered flat lined. There’s low volatility and minimal dispersal in returns between stocks. That puts a crimp in an active manager’s position. If they did make the right picks, stocks might not outperform the market enough to compensate for management fees.Utermann believes passive management has played its part in keeping active managers alive. The uptick in index funds, alongside a bump in herding, lets active managers maintain a close position to benchmark indexes. That exposes them to minimal risk for less than stellar performances. Still, on paper, this is an investment strategy that has no logic at its foundation.

Utermann believes the investor has evolved. With indexers in the mix, active managers have to keep a distance from an index. Academics have measured the extent of index hugging. Active share, the portfolio percentage that sets it apart from its benchmark index, is followed closely. The greater active share gets linked to higher returns. Under Utermann’s theory, returns on equities and bonds over the coming ten years, given historically disappointing yields on bonds, will probably stay low and value stocks. This would force managers to go in other directions.

Indexers tend to lean towards the pro-cyclial or go for longer going trends. As the stock goes up, index funds will buy more, enhancing the possibility of counter-cyclicality. As cash continues to flow into passive funds, markets will become less effective.

One has to factor in the small-cap effect. Studies demonstrate small companies will outperform as their market value is inefficient. Pre-financial crisis, with the small-cap effect growing, the Street constructed research teams to cover small-caps. This led to everyone jumping in. This made the market more efficient. But the post-crisis layoffs flipped the situation. Investment banks went the other way. This created more opportunities for active managers.

Following Utermann’s thesis, index funds won’t squeeze out active funds. Instead, it will lead to activity and grow hedge funds. We could see a scenario where the investment industry protects savers while allotting capital efficiency. Aggressive managers could potentially grab up the very anomalies they created while money is held passively. While being too efficient for savvy investors to beat on a regular basis, markets are not perfectly efficient. This is the major barrier for active asset managers. They are constrained by evolution and it is inevitable that their numbers will shrink because of it.


Author: K. Michael Williams


One response to “Index Funds Will Put Active Asset Managers out of Business

  1. Pingback: This year we had the worst equity fund managers of the decade. Well done! | Alpha Banker·

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