The trend of shifting investment allocations from active to passive management has accelerated in recent years. “Since the end of 2006, investors have withdrawn nearly USD1.2 trillion from actively managed US equity mutual funds and have allocated roughly USD1.4 trillion to US equity index funds and ETFs.” (“Looking for Easy Games”, Mauboussin, Callahan and Majd, Credit Suisse, 2017)
It is simply a mathematical fact that active investing in aggregate produces market returns minus costs. Empirical evidence overwhelmingly supports the findings that net of fees, the majority of active managers underperform the market. Does it really make any sense for most investors, particularly the ones who are less informed, to engage in this negative-sum game?
On the other hand, active investing does produce a very valuable social good: the discovery of so-called efficient prices for all financial instruments, a key foundation upon which market-driven capitalist systems are built. An economy with no active investing would be extremely inefficient from a capital allocation point of view.
One of the key questions to address in this debate is whether the current balance of active vs passive is appropriate from an aggregate/society point of view, which in turn would inform whether the current shift towards passive is value-enhancing or value-destroying for society.
In order to answer that question, let’s evaluate active management as a social good, by comparing the aspects of price and value. Warren Buffett once famously made the statement that “price is what you pay and value is what you get”. The net gain for the society is the difference between two: value (V) – price (P).
The price/cost of price discovery is relatively easy to calculate. One can measure the total amount society spends to invest (A) and then compare this cost to what society would pay if all investors held a passive market portfolio (B) – the difference (A-B) is the cost of active investing/price discovery. Kenneth French used this exact logic in his 2008 American Finance Association presidential address, suggesting that for the period of 1980-2006, investors on average spend 67bps of the market cap in the US for price discovery (P).
The value bit is, however, much trickier. In theory, it is the economic loss to society due to inefficient asset prices in a hypothetical state where there is no active investing at all compared to another hypothetical state where prices are completely efficient. (Grossman and Stiglitz (1980), however, made it clear that pure efficiency is fleeting: market inefficiencies are a necessary incentive for investors to engage in active investing). In practice, the value of price discovery is very difficult, if not impossible, to calculate.
A new study (latest draft on 23 December 2016) by two Wharton professors (van Binsbergen and Opp) addressed a different but relevant question: how much potential value could society gain if all informational inefficiencies in current asset prices were eliminated? The authors quantitatively assessed the real value losses associated with financial market anomalies. It is well known that firms make the wrong investment decisions as a result of distortions in market prices and the cost of capital. The maths is complicated but the conclusion is clear: society could gain value that is worth 10.6% of public firm net payouts for eliminating price inefficiency completely. I have used free cash flow as a reasonable proxy for the paper’s net payouts. Given the latest reading of free cash flow yield for the S&P 500 of 4.7% (as of 23 Jan 2017), the potential value to society of eliminating all existing price inefficiencies in the S&P 500 is around 50bps of the market cap. This finding, that there is still value on the table, provides an incentive for the job of price discovery. The lack of a suitable counterfactual, however, means that we cannot quantify directly the amount of value (V) that active management has delivered from a base of complete market inefficiency. Nonetheless it is probably reasonable to assume that the more efficient financial markets are, the less the economic gain would be from further reducing pricing anomalies and the higher the value society was deriving from active investing (everything else being equal).
There is evidence suggesting that financial markets have become more efficient. Bai, Philippon and Savov (2015) claimed that using certain measures, prices in financial markets were 80% more efficient in 2010 than 1960, well before the first ever index fund was launched. The upward trend in improving market efficiency is steady throughout the 50-year sample. Along with a shift towards passive, in the last few decades we have also experienced the rise of high-cost and highly-active alternative sectors like hedge funds. It is plausible to suggest that these two trends together produced better price discovery for society (V).
How about the cost (P)? The aforementioned study by Kenneth French covered a shorter period of 1980-2006 and his data indicated a relatively stable P throughout the entire period (starting with 64bps in 1980 and ending at 66bps in 2006; 1983 and 1986 saw the highest 74bps and 1981 saw the lowest 56bps).
I believe this shows the investment ‘system’ is a dynamic ecosystem (or complex adaptive system, in deeper jargon). The system has acted as a search engine to find a more optimal solution – better price discovery for the same spend. It looks to have achieved that by barbelling from active to both cheap passive and expensive high active. So much for the past, what happens now? It is reasonable to expect the system to continue searching for an even better position, and that could involve more in passive, lower fees on hedge fund allocations, and a further shift from 200-stock traditional active portfolios to 20-stock high-conviction portfolios.