Life is full of unintended consequences, and very few developments are wholly good or bad. The long, steady shift from active to passive fund management may seem like a good thing – better performance and lower fees – but there are some major potential negatives.
Passive fund management is best defined as simply tracking an index or benchmark with little or no human intervention. The passive fund probably won’t actually buy all the index constituents and will instead use a blend of purchases, derivatives and sampling. The fund will almost certainly underperform the selected index due to dealing and management fees, but the gap tends to be small and transparent.
Active fund management is harder to pigeonhole. There are many different strategies, but the unifying feature is that the manager thinks that he or she can beat whatever benchmark has been selected. The theory is that an individual manager can spot market inefficiencies and construct a better portfolio. The fees may be higher, but superior returns should justify the cost.
Unfortunately for active fund managers, the evidence is not on their side. According to Morningstar, active funds have underperformed passive funds almost every year since 2003. Statistically speaking, it is very hard to work out whether the better active funds have been better managed or just lucky.
The decline of active management makes the process of floating companies steadily more difficult
Critical factors
The unsurprising result is that investors have been steadily shifting from active to passive for many years. 2023 was a watershed, with total passive funds by value exceeding active funds for the first time ever. Maybe the trend will slow or reverse at some stage, but there is no sign of this in the data.
There are many reasons to be critical of active fund management. As well as underperformance, we can add opaque charging structures, exit fees, reluctance to vote against management, closet index tracking and, more recently, allegations of ESG greenwashing. Some of the largest fund managers are privately owned, making it almost impossible to analyse how they operate. Despite this litany of complaints, active managers provide some critical functions that help markets function effectively.
Passive fund managers never read the annual report as there is no need
The market for Initial Public Offerings (IPOs) is almost totally reliant on active managers. In 20 years of doing investor education for IPOs, I have never met a single passive fund manager. IPOs are a vital part of capital markets, and the decline of active management makes the process of floating companies steadily more difficult.
More subtly, markets need active buyers and sellers to function properly. A totally passive market would likely be volatile and with low trading volumes. Short sellers get a bad press, but are a crucial part of pricing assets appropriately.
End of oversight?
Passive fund managers never read the annual report as there is no need – they just mimic the index. They also don’t lobby for better accounting standards, look out for corporate fraud or pile into promising young start-ups. In a wholly passive world, the concept of investor oversight would vanish, which I think would be a tragedy.
I do not like the idea of three unaccountable firms having about a quarter of all voting rights
The final problem with passive management is that it is a natural oligopoly. The three largest managers have about half the global passive market, which gives them tremendous voting power, should they choose to use it. I do not like the idea of three unaccountable firms having about a quarter of all voting rights.
The health of the accounting profession is dependent on the development of robust standards that serve the needs of investors and other stakeholders. As active fees steadily shrink, the number of professional investors who have the time and inclination to engage with regulators is also shrinking. Be careful what you wish for.
