With the increased popularity of passive investing in exchange-traded funds (ETFs) and index funds, it’s no wonder they’ve gained the attention of asset managers whose careers are built on picking stocks. Recently, stock analysts have been weighing in about the potential for a passive investing bubble, and it’s definitely been getting the attention of investors. The proposition they’re making is that the passive equity market is having an unwelcome effect on traditional stock markets.

The combined ETF and Index markets reached 4.271 trillion dollars in August 2018, eclipsing $4.24 trillion in actively managed equity funds, the first time that the value of passively managed equity surpassed actively traded funds. The idea being discussed is that somehow, the trading activities of passive investing funds are causing stock market volatility. Here’s what you need to know.

How passively managed funds compete with actively managed funds

What’s causing the increased popularity of ETF and index funds? Passive investing has been around since the 1970s. However, after the major economic downturn of 2008, investors became more sensitive about paying manager fees. They began to realize that indexed funds were performing better than some actively managed funds. Investors prefer the predictability of modest returns and long-term stability but at much lower fee schedules. The average cost of passive equity fees is only 10 cents per $100. Actively managed funds, on the other hand, cost 70 cents per $100. Hedge funds, commingled, and closed-end fund fees can go even higher— over one dollar per $100 invested. According to Morningstar, investors added $88.9 billion to passive U.S. stock funds while pulling $124.1 billion from active this year through August, the firm estimated.

What economists are saying about the “bubble” notion

Economists aren’t convinced that the passive equity market has anything to do with market volatility. According to Shelly Antoniewicz, Senior Director of Industry and Financial Analysis for the Investment Company Institute (ICI), fund inceptions and redemptions in the primary ETF market made up less than 5% of the combined equity market trades during unusually turbulent months. What they should be looking at, she says, are inceptions and redemptions on secondary exchanges where the trades don’t involve the underlying securities.

We need to be looking closely at the institutional investors who arrange with exchange-traded fund managers themselves to create and redeem those shares. Authorized participants, as they are called, structure large purchases of ETF shares before they ever get released to the public for trade. Asset managers haven’t investigated how to differentiate between trading activities of secondary and primary market shares. Some are even saying that passive strategies will become less effective the more investment capital they attract.

This is not to say that active managers aren’t successful at developing proven strategies that regularly beat the benchmarks of peers. They do. However, you must also consider that the higher returns can get offset by the higher fees. When a fund experiences a monthly returns loss, the fee then really comes into focus when it’s calculated at the same percentage of the ending market value.

To active manager credit, limitations of ETFs and indexed funds become apparent during “bear” markets. Passive management means that managers of those funds can’t make numerous changes to their stock holdings. It also means that any large value adjustments will not happen quickly, regardless of how a market sector is performing. Because competition is so stiff, it has become increasingly difficult for one manager to outperform another expert.

ETFs can diversify your assets

If you are hesitant about investing in ETFs because you want to maintain portfolio diversification, it’s good to know that there are a lot of options in the market. You can begin to explore ETFs by sector, value vs. growth, market capitalization, and themes. Themes address matters important to the contentious investor and have a focus on social, environmental, and economic matters. To say that passive investing has an impeding bubble is to suggest that the strategy has never been a good one. It has been tremendously successful. Not only because historical returns have successfully outperformed actively managed funds, but because investors have been able to take charge of their planning decisions with low-fee, easy-entry funds. An experienced wealth manager can review your portfolio, especially if you have ETFs and Index funds or if you are considering adding them in.

SD Mayer has the market research you need to make better passive equity and investment decisions for your assets. Our advisors have decades of combined experience and are ready to help you take a holistic look at your portfolio, anticipate issues, and meet your financial goals. Contact us today to set up an initial consultation.

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