What's next in the duel between active and passive?

Why index-following strategies' historical dominance could be tested by recent innovation

What's next in the duel between active and passive?

While some passionate advocates of stock-picker style investing might argue the strategy is poised to overtake passive funds’ performance given the current backdrop of volatility, only time will tell for sure. For now, many investors can only rely on history and past evidence, which has so far consistently showed an overwhelming mismatch.

“I would say that the empirical evidence and research done by educated and very intelligent people seems to show that over a long-term timeframe, passive does tend to win out and to outperform versus active,” says Rahul Sen Sharma, Managing Partner of Indxx. “That said, quite a lot of active ETF launches have happened over the last year or two, and also quite a lot of ETF conversions from actively managed mutual funds.”

Those conversions were enabled by regulatory changes in the U.S. a few years ago, which allowed the proliferation of non-transparent ETFs. As the ETF structure’s efficiency advantage over mutual funds in a number of areas makes the former more appealing, many fund providers have been keen to offer their successful active mutual strategies in a lower-cost ETF wrapper.

At the same time, active managers have been able to develop new strategies and launch them as ETFs from the outset. That represents a major shift from the attitude a decade ago where managers weren’t convinced of ETFs’ prospects of adoption.

“I think seeing the success of certain active ETF managers also influences other players to come into the space,” Sen Sharma says.

Of course, the index-based space has also been on the move. Fund managers have been able to offer passive strategies built not just around broad indexes, but also more niche or customized exposures. That includes thematic indexes, which give people exposure to secular trends that are expected to last for the long run, and often transcend the boundaries of sectors and geographies.

“We expect the thematic indexing space to continue to grow over the next five to 10 years,” Sen Sharma says. “The thematic indexes that we build as an index provider are long term and disruptive – they're not flashes in the pan. These are themes that we expect to be transformational.”

As one example, Sen Sharma points to infrastructure as a robust theme; that’s expected to be catalyzed by an expected multitrillion-dollar, multi-decade strategy of spending in the U.S. aimed at revitalizing the country’s economy and future-proofing its infrastructure.

He also underscores the metaverse, which envisions an extreme continuation of digitization as people embrace the internet and virtual reality as integral to their lives and identities. While that trend is still arguably in the primordial stages of its evolution, Sen Sharma expects the metaverse will be significantly more important and disruptive than it is today.

“What we expect big picture for the thematic indexing space is that it will continue to grow globally,” he says. “Societies are always changing. Civilizations are changing. There's always new opportunities that come up. So we believe there’s still quite a lot of whitespace for thematic indexing to fill.”