I'm minding my portfolio.

Photographer: Alberto Buzzola/LightRocket/getty images

The Rise of the Most Powerful Idea in Investing

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
Read More.
a | A

The biggest story in the finance industry during the past decade might not be the 2008 crisis, or new regulation, or even record-low interest rates. Maybe it's the shift from active to passive-investment management. In the realm of mutual funds, the change is stunning. Here is a picture of fund flows in billions of dollars since 2007:

Source: Investment Company Fact Book

Why is this happening? One reason is technology, which makes it much easier to trade large numbers of different assets at the same time, and to construct baskets of assets that track indexes closely. Another factor might be low interest rates and declining returns, which make asset-management fees more salient and painful, pushing people toward low-fee passive-investment vehicles.

But the most important reason might just be the power of the passive idea itself. The efficient markets hypothesis, which won economist Eugene Fama a Nobel Prize in 2013, might not be strictly true, but it’s never totally false, either. Financial markets do a decent, if not always perfect, job of scooping up available information about the value of stocks and other assets, and incorporating this information into the price. People who try to beat the market are likely to lose, since they tend to be trading on stale information, while paying fees at the same time.

Instead, why not just sit back, skip most of the fees and earn the market average return, sometimes known as beta? You’ll be doing better than more than half the money out there in the market, and saving effort besides. The relentless logic of this approach has been promoted for decades now by asset managers like Vanguard Group founder John Bogle and academics like Princeton economist Burton Malkiel.  It has been supported by academic research showing that active managers tend not to beat the market after fees, and that individual investors make bad decisions when they manage their own money actively. Eventually, logic and evidence tend to win out -- with the rise of passive management, we may simply be seeing a great idea come into its own.

Of course, much active management still remains. The tactical allocation strategies used by many wealth managers are attempts to time the market, and the so-called smart beta universe includes some strategies that are really more like active alpha-seeking of above-market returns. Also, while index funds and exchange-traded funds can track indexes of stocks or bonds within a country, there is as yet no index that represents a value-weighted combination of all assets in all countries. So investors or their managers still have to decide which asset classes and which countries to allocate their money to -- and that too is a form of active management.

So active isn’t dead, but it’s shrinking. Therefore I think it’s worth asking what the endgame of this trend might be. As passive takes over more and more of the asset-management universe, will the market become more efficient, or less? Will we reach a point where active makes a comeback?

One answer is in a 1976 paper by Sanford Grossman and Joseph Stiglitz. These economists realized that if it costs money and time to get information about asset fundamentals -- like a company’s future earning, or a country’s chance of default -- then financial markets can’t be perfectly efficient. If they were, there would be no compensation for gathering information, so no one would bother to do it, with the result that markets would come totally unmoored from reality.

In the ideal situation, Grossman and Stiglitz found, the inefficiencies in the market -- which let active managers beat the average -- will be exactly big enough to compensate active investors for the costs of gathering and interpreting information about fundamental value. Market prices will be as “right” as they can be, given the basic costs in the system.

As passive management increases as a percent of the total, we should move closer and closer to that ideal point. More passive means that fewer and fewer managers are out there trying to figure out what companies are really worth. That means more opportunities for the few people left who are trying to figure this out and make bets on it.

Eventually, we’ll reach a point where active management, even after fees, does as well as passive. The case for index funds and ETFs will become weaker and weaker, until average investors will be about as well off with an active manager. Meanwhile, the best active managers will become proprietary traders, shunning outside money and making their services unavailable to the investing public.

That’s the ideal endgame. But how will we know when we’ve reached this point? The answer is that even after we reach it, it will take a long time to realize we’re there. To be confident that active managers do as well as passive ones net of fees, we’ll need decades of data. In those intervening years, we might actually overshoot -- people might invest too much in index funds and ETFs, and not enough with the people who actually look at fundamentals.

So active management might one day make a comeback, but not until well after the comeback is needed.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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

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