Passive Investing: Yesterday’s Growth Industry?
By: Robert Tattersall
In my view, the most significant development in pension fund investing during the past 15 years has been the growing acceptance of passive investing, either in the form of index funds or Exchange Traded Funds (ETFs). This trend has not been confined to pension fund investors, of course, as retail investors have also shown a similar interest. As a result, a signifi cant amount of trading on the Canadian and global stock markets now represents passive index investing.
The growth of passive investing is understandable when we consider the number of manager search consultants and mutual fund commentators who point out that the average equity manager lags the benchmark index by the amount of management fees plus transaction costs.
In addition, there is an academic argument in favour of index funds. Thousands of investors are out there researching individual companies and then buying or selling stocks based on this analysis.
All of this activity makes the market ʻefficient,ʼ so no individual investor can consistently outperform the market on a risk-adjusted basis. But, if everyone moves to passive investing, then no stock research is being performed and the market becomes ʻinefficient.ʼ Valuation anomalies begin to reappear which some investors exploit and, as a result, outperform.
At this point, index funds represent less than 50 per cent of the market, so this doesnʼt seem to be a problem that pension fund investors need to address just yet. But, if we add in ETFs and ʻclosetʼ index funds, then the total volume of passive investing may be much higher than we realize and the problem more immediate. A couple of professors at Indiana University (Bhattacharya and Galpin) tackled this question late last year.
Their starting point is that if a market is driven entirely by passive investors, then the percentage of the dollar volume traded in a stock should be equal to its percentage weight in the total market. Investors would allocate new cash or redemptions exactly in line with the index and, as a result, deviations in trading volumes from this equilibrium represent the maximum amount of trading that can be explained by stockpicking.
Armed with this analytical tool, the two professors looked at the U.S. equity market from 1960 and other global markets from 1995 to 2004. Some of their observations suggest that passive investing may soon become a victim of its own success:
- Stock-picking peaked at about 70 per cent of all trading activity in the U.S. in the late ʼ60s. In the last five years, it has fallen to 24 per cent of trading.
- In Canada, stock-picking declined from 72 per cent of all trading in the 1995/1999 time frame to 47 per cent in the 2000/2004 period.
- In other developed markets, stock-picking in the latest five year period ranged from a low of 30 per cent in Belgium and Sweden to 50 per cent in the UK and highs of 69 per cent in Germany and 80 per cent in Hong Kong. What conclusions should a pension fund investor draw from these observations?
Think of it this way. As a stock-picker, would you like to compete in a market such as Germany or Hong Kong, where you donʼt speak the language and more than 70 per cent of the trades are based on company-specific information which you may not know? Or, would you prefer to compete in the U.S. market where 76 per cent of trades are executed by people who donʼt know anything about the stock except for the ticker symbol and the weight in the S&P 500 Index?
As a bottom-up stock-picker and faced with this choice, my vote goes to the U.S.
My conclusion is that passive investing will remain the preferred strategy for the mega pension funds, simply because they are too large to consider any alternatives. For smaller funds, picking an active manager remains a viable option if the goal is to outperform an index.
Paradoxically, it may make more sense to hire an active manager in the highly liquid but ʻinefficientʼ U.S. market and an index fund for the exotic offshore locations.
Robert Tattersall is executive vice-president and senior portfolio manager at Howson Tattersall Investment Counsel.
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