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Stock Picking Will Never Die

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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For decades now, finance professors, financial journalists, Jack Bogle and Vanguard have been trying to hammer it into your head: Active management is bad. Don’t pick stocks. Diversify. Buy low-cost index funds and exchange-traded funds.

Now it seems like the world is finally beginning to listen. As John Authers of the Financial Times reports, money is pouring out of actively managed mutual funds and into passive funds:

[S]ales of actively managed funds have collapsed, particularly in the huge market for US funds investing in equities. Over the past 12 months, such funds saw redemptions exceed new sales by $92bn, even as rival passive funds took in a net $156bn.

The money from institutions and retail investors that was already flowing instead to rival passive funds has turned into a flood. Fidelity Investments, once the world’s largest fund manager, saw $24.7bn flow out of its active funds this year; Vanguard, its successor as the largest US mutual fund group, took $188.8bn into its passive funds.

Of course, these are flows, not totals. The vast majority of the world’s financial assets are still actively managed. Even by 2020, PricewaterhouseCoopers forecasts that only a little more than a fifth of global assets will be passively managed. But we may have seen a turning point -- signs point to a long, slow, inevitable decline of active management during the next few decades.

Why is this happening? One reason is that the so-called folklore of finance -- the belief that if you’re savvy and well-connected you can find a money manager who will beat the market for you, even after fees -- is being replaced by a new, more fatalistic folklore grounded in academic evidence. Academics and private-sector research firms alike have been hammering away, year after year, with studies showing how few money managers can beat the market, and how little their success persists from one year to the next. Expect those studies to continue coming out. Meanwhile, people are beginning to realize that even if some hotshot hedge-fund managers do beat the market, they tend to keep their winnings for themselves instead of passing them on to you, the investor.

Next, passive investing has gotten easier. The rise of ETFs means that you can buy and sell the entire market -- or a big slice of it -- as quickly as you can sell a single stock. Investors tend to value liquidity, and ETFs give you the diversification of an index fund with a little more liquidity. Sometimes a little is all it takes.

Third, we live in an age of low interest rates. That tends to make fees more salient, and active management has higher fees than passive management. A 2 percent annual management fee is easier to stomach when interest rates are 6 percent than when rates are at 0 percent. In other words, the low-rate environment probably forces money managers to compete on price instead of on promises of high quality. But even if rates rise, it seems far from certain that active money managers will be able to jack their fees back up to mid-2000s levels, once investors have gotten used to paying tiny expense ratios for ETFs and such.

But as active management wanes, some industry observers have begun to question what “active” even means. The definition is blurrier than it looks. Once upon a time, “active” meant picking stocks, and “passive” meant buying and holding an index fund. But nowadays, your country’s stock market is only one of many assets you can invest in -- there are foreign stocks, risky bonds, commodities and real estate. To truly and completely diversify, you have to hold all of these to some degree.

Of course, you can do that with ETFs. But in what proportions should you hold these various broad asset classes? It isn't at all clear, since the true total value of these assets isn't easily calculated. Deciding how much money to put in foreign versus domestic stocks, for example, is an active decision that even passive investors have to make.

Asset-class picking, in other words, is the new stock picking.

There is also the issue of market timing. Traditionally, this goes under the heading of active management, and research shows that people are poor market timers. But many of the strategies that even academics recommend, such as dollar-cost averaging and yearly rebalancing, are really about market timing. Since a large and increasing amount of diversified investing is done via ETFs, and ETFs are highly liquid, this makes it easier to decide when to get in and out of the market as a whole. This is a fundamentally active decision.

So active management may not be dying,  though  investing is getting less and less active over time. Active and passive management are best seen not in black and white but in shades of gray. Spurred by research, new technology and macroeconomic changes, investing is getting more diversified and lower-cost. But the need to make judgment calls will never go away.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net