We observe increased discussion about passive trends in indexing, whether a bubble has developed, and the future of active investing. There is always a desire to exploit predictable cyclical opportunities, yet it can be extremely difficult to forecast when active management should outperform. Below we discuss what is driving the passive rotation, as well as how strategies and products evolved to suit investors’ changing needs.

While ETF (exchange traded fund) flows since 2005 have been spectacular, mutual funds still hold $16.3 trillion or 83% of total U.S. listed fund assets. We don’t find arguments for a bubble very compelling, and will discuss why in greater detail below. Our belief in the theory of Rational Beliefs (vs. Rational Expectations) with relatively efficient markets supports that as long as a few good active managers exist with differing rational beliefs adapting over time, Passive Carnage Is Illogical.

Source: www.etfgi.com

Today there are over 2,025 U.S. ETF products with $2.8 trillion in assets. Growth in passive allocations has been impressive, but the ETF market has been dominated by iShares (Blackrock), Vanguard, and SPDRs (State Street) with about 70% market share of $4.1 trillion globally. This concentration is in part due to licensing of indices, which limits competition in primary benchmark indices like the S&P 500, MSCI EAFE, or the U.S. Aggregate Bond Index. This has driven higher acquisition valuations of index providers (i.e., Bloomberg-Barclays, FTSE-Russell), while Vanguard boldly partnered with CRSP to reduce licensing costs.

Source: ICI, 2017 Investment Company Factbook

The chart above suggests passive investing is displacing active management, but it fails to tell the whole story. Mutual fund flows as a proxy for active management is misleading, while 25% of equity mutual funds are passively indexed (ref: ICI). Listed funds are only a portion of total market capitalization, ignoring separate accounts and security holdings of asset owners (pension, sovereign wealth and family office). Perceived decline in active management is likely exaggerated by narrow ICI fund flow measures.