How ETFS make it harder for active managers to win

With the rise of passive investing, veteran traders are left to gamble among themselves

How ETFS make it harder for active managers to win

Investing is a zero-sum game: for every investor who makes a winning trade, there has to be a loser on the other side. Similarly, the success of ETF-based investing has made things easier for stock-market rookies — and tougher for active managers.

“ETFs are providing a refuge for weak investors and in so doing are making it harder for active managers to achieve alpha,” reported ETFStream.

Citing a study by Credit Suisse, the report noted that money managers and professional traders are more able to create alpha when novice investors play the market. The more collective inexperience they can take advantage of, the greater their chances of making profitable bets.

But the study found that ETFs are undermining this dynamic. More and more novices are finding sanctuary in ETFs, and the weaker stream of weak investors makes it harder for active managers to achieve alpha.

Using poker as a metaphor, the report said that novice investors are becoming less inclined to sit at the table with skilled traders. They will move to passive funds more quickly, particularly during bear markets when losses sting most severely.

Still, retail investors aren’t the fastest when it comes to jumping on the ETF bandwagon. Looking at data from 2014 to 2016, Credit Suisse found that institutional investors have been reducing their active allocations to US domestic equities more quickly than retail investors, despite the fact that small investors have more to gain from switching.

“Individual investors can be a good source of excess returns for institutional investors,” the report said, noting that the average individual investor tends to underperform the market both before and after fees. “Individuals are generally overconfident, causing them to trade too much. Institutions generally have better information and analytical skills than individuals do.”

The report also noted that the passive-fund takeover can only run so far. In a market dominated by passive managers that don’t actively research or consider value, inefficiencies will arise for active managers to exploit.