Two major drivers behind the passive-fund industry’s rise may be sputtering
As the global leader in index investing, Vanguard has encouraged investors to embrace a passive investment mentality. That has meant buying funds on online platforms and holding them for extended periods, letting the markets do the work of producing healthy returns.
But several days of nosediving markets last week exposed potential chinks in Vanguard’s armour. On Wednesday and Thursday, US bourses saw red as fears concerning rising rates and trade tensions took hold. Amid that turmoil, according to the Financial Times, Vanguard tweeted the following message:
“You know the drill. In the face of market volatility, keep calm and stay the course.”
Not all of their clients were keen to follow that advice. Many attempted to access their accounts and execute trades, only to encounter glitches in Vanguard’s online and phone support facilities.
“Having investors who might want to sell — and fast — is not something Vanguard or any other [index-fund-focused asset manager] has been used to over the past decade,” wrote Patrick Jenkins, financial editor for the Times.
Citing Morningstar figures, he noted that in the US alone last year, passive equity strategies saw inflows of US$470 billion, while their active counterparts suffered net outflows of US$175 billion. Looking mutual funds and other similar pooled investment products, passive mandates now make up almost half of all assets managed in the US and Asia, and a third of the total in Europe.
Jenkins noted two key tailwinds behind the rise of cheap passive investing. First was the years-long bull market that has left question marks all over active managers’ selling propositions. Second was the rise of technology that’s helped facilitate fund companies’ operations and allowed their investors to buy and sell the funds with little fuss.
But last week was a wake-up call for investors who might have started to believe in a story of never-ending growth and hitch-free trading services. “It is impossible to say how soon last week’s ‘correction’ will be repeated, but it is fair to assume it won’t take that long,” Jenkins said. He noted that US President Donald Trump’s criticism of the Federal Reserve notwithstanding, US rate hikes are likely to go on, and that trend could take off in Europe next year.
“[T]here is one inescapable truth: in a higher interest rate environment, equities lose some of their lustre,” he said.
With turbulence increasingly in the forecast for the markets, investors might see the basic threats of the US$3-trillion ETF market come alive. Those include concentration risk from a US index driven largely by a few tech titans and herd risk from funds selling at the same time.
Jenkins also referred to analysis from active UK fund manager Schroders, which suggests the shift to passive investment has coincided with more correlation between stocks and, when those stocks start to move, more volatility. And while smart-beta funds might be a good middle road, but that has not been tested under stressful market conditions.