Passive funds and market efficiency
16 January 2017
Learning Objective – to explain how active and passive funds interact and how the increasing size of passive funds may indirectly improve active fund performance, thereby helping market efficiency.
The Financial Conduct Authority (FCA) published their interim findings from their Asset Management Market Study in November 2016. The scope of the report is very broad and assesses if the fund management industry as a whole, including fund management firms, distribution, platforms and IFAs, is delivering value to clients.
The report places a particular emphasis on costs, which is sensible given that even small differences in annual costs can compound into a large impact on net returns over long periods of time. Many salient points have been raised, one of which is the role, prominence and availability of passive funds (or index trackers) to retail investors. For example, the report states that while active fund management fees appear to have remained stable over the last 10 years, many active fund annual management charges (AMCs) ( are clustered around 0.75%, and there is no evidence that more expensive funds are more likely to outperform their benchmarks. (Keep in mind an 0.75% AMC implies an ongoing charges figure (OCF) of roughly 1.5% for the retail investor, once other fund charges have been included.)
With these points in mind, one could be drawn to the conclusion that passive funds offer a better alternative. Investors have indeed become aware of this and the growth in passive funds has been dramatic. Currently about ⅓ of funds invested in the US S&P 500 index are passive. In the UK the Investment Association (IA) reports the level of passive funds at 24% of total assets.
A common misconception is that the rise of passive funds will make the market less efficient or competitive. It is easy to imagine this given the passive strategy of blindly replicating a benchmark as closely as possible and passive investments taking a ‘free ride’ on active fund positions. However, it is worthwhile considering how investment markets work in reality and how passive funds operate alongside active ones.
Consider that the vast majority of securities traded on exchanges form the ‘secondary market’, ie these are existing securities and are traded directly between buyers and sellers. (Compare with the ‘primary’ market, which involves companies raising capital via raising debt, initial public offerings (IPOs) and equity rights offerings). As trade on exchanges is effectively a closed system, this implies that for any investor to make more than the average requires another investor (or several) to lose by an equal amount. In other words, investing against a benchmark is a zero sum game
If passive funds are only trading to match their passive fund performance to the benchmark (or average) exactly, the only way for an active fund to do better than the benchmark is for another active fund to lose. In this way passive funds have no impact on market efficiency and how individual securities are valued.
However, there is another indirect effect. Previously, an investor who was unhappy with the performance of his active fund would only have the choice available of other active funds. As the FCA report states, few active funds can outperform the benchmark on a consistent basis over the long-term, and knowing these funds in advance is very difficult. Having a passive fund available means the investor can almost guarantee a market return, minus a small amount of passive fund cost and tracking error, instead of making the more uncertain investment in another active fund. In turn, the removal of investments from active to passive funds in the market actually increases the level of competition for the remaining active funds: not only do active funds have to compete with each other, but if they don’t beat the benchmark then they will lose to passive funds over the long-term.
Obviously, there is a limit to how far this trend can go. If the market is entirely passive then there is effectively no market, valuations won’t change and securities will have valuations out of line with their fundamentals. Where the equilibrium between active and passive funds might lie would involve comparing the costs of running an active fund against those of a passive, for example costs of researching company fundamentals, trading/brokerage costs and marketing.
If we approach the point where passive funds are too large, we would see an increase in trading costs for them, for example if too much investment is attempting to purchase a security that is entering an index. Meanwhile, we would see a streamlining of active funds such that on average we would expect the average active fund return, net of fees, to be at least in line with the benchmark (as opposed to underperforming). As highlighted by the FCA report, over the last 10 years there hasn’t been any noticeable increase in costs for passive funds (in fact, the reverse), or issues with liquidity causing tracking error to decrease. Meanwhile active fund costs have remained static.
Considering the above, in all likelihood the move into passive funds will continue. Active funds will continue to feel cost pressures, and those who cannot beat their benchmarks will come under pressure from fund withdrawals. We will also see a continuation of the recent trend for active funds to move into strategies that aren’t benchmarked against a market index, for example absolute return or return-focused strategies. We may also see passive funds move into return focused strategies, which arguably ‘smart beta’ funds are attempting to do. (Smart beta funds are passive funds that track a return focused index that is based on a mix of investment ‘factors’, for example small cap stocks or stocks with a low price-to-earnings ratio.) Ultimately investors should benefit from having cheaper funds available and those that more explicitly match their aims, even if the FCA has had to get involved to highlight these areas to the current crop of active fund management firms.
Defaqto has been a ratings leader by highlighting passive funds within our ratings. In particular, within our Return Focused and Risk Targeted ratings we rate active and passive funds within the same sectors and using the same metrics. We also rate passive funds in their own distinct rating sector.