Epic Shift Sees Passive Funds Pass Active as Stock Pickers Retreat

The market has reached a major milestone with the size of assets in passive index funds and ETFs surpassing actively managed funds for the first time ever. This event highlights the decline of traditional stock pickers that gained speed after the 2008 financial crisis, when investors were stung by huge losses, prompting them to pile literally trillions of dollars into to these low-cost funds. Passive funds' extraordinary success comes as some investors warn that they are extremely vulnerable to a major market downturn, according to Bloomberg in a detailed story as outlined below.

The trend “represents investors keeping more of their own money,” said Bloomberg Intelligence analyst Eric Balchunas, adding, “If there’s a loser in this, it’s probably the asset-management industry." To many investors, the cost savings are irresistible. To put money in U.S. passive funds, investors pay an average of about 10 cents a year per $100 of assets, compared with seven times more, or 70 cents, for active funds.

What it Means for Investors

Last month, passive funds finally overtook active ones. The total amount of assets in index-tracking U.S. equity funds reached $4.271 trillion, $25 billion above the $4.246 trillion in funds managed by active stock-pickers. From the start of the year through August, passively managed funds saw inflows of $88.9 billion while active funds saw outflows of $124.1 billion, according to Morningstar estimates reported by Bloomberg.

Many investors' preference for low costs may cause them to overlook some of the risks. The big worry is what happens in a market downdraft when there’s a rush for that exit door. Inigo Fraser-Jenkins, head of global quantitative and European equity strategy at Sanford C. Berstein & Co., recently warned that the tail-risk of a disorderly market sell-off has increased. “A sell-off is not our forecast, but were one to happen we basically do not know what will happen when thousands of investors reach for their smart phones and try to sell positions that they have in passive ETF products.”

Michael Burry, who was made a key figure in Michael Lewis’s book, “The Big Short,” for correctly calling America’s subprime mortgage crisis, is also concerned. He warns that inflows into passive funds are starting to look frothy and akin to the pre-2008 bubble in collateralized debt obligations (CDOs), the complex securities that helped to bring the financial system to its knees. 

Burry believes that passive index funds have removed price discovery from equity markets. Such funds, by allowing investors to invest in a collection of stocks, do not require analysis at the individual security level, which is where true price discovery happens. He warns that a bubble is forming as the cash invested in passive funds exceeds the amount invested in the individual stocks themselves, he told Bloomberg in an e-mail interview.

Looking Ahead

If Burry is right about the parallels between passive funds and CDOs, then investors have at least a hint of what might happen—a severe liquidity crisis that makes the job of the market makers supporting these investment vehicles almost impossible. That is the scenario that regulators across the globe are becoming increasingly worried about.