In the United States last year, $470bn went into passive equity strategies * and a net $175bn flowed out of the country’s actively managed equity funds. Passive funds now account for close to half of the funds in the US and Asia, and a third of the total in Europe*. The proportions have more than doubled over the past decade. This is to be expected in a bull market. Why would you pay fees to an active manager who might have actually underperformed the market? At the same time, fees on automated passive funds have been tumbling, maximising the compounding effect of asset growth. A charge of just 0.1 per cent on a mainstream exchange-traded fund now seems standard but soon the standard will be zero. The rise of technology has been instrumental — both in facilitating the asset managers’ own operations and in allowing their investors to buy and sell into the funds with minimal friction. No wonder the sector has experienced record growth.
We have just witnessed a sharp fall in the global stock markets. Big asset managers (Vanguard, in this case) urged in a Tweet, “You know the drill. In the face of market volatility, keep calm and stay the course.” It may not be in your interest to panic in the long term, but it is certainly not in the asset managers interest you sell their funds. But you could not sell anyway because of a computer failure on Friday. Clever tech, a long bull market starting to falter in a rising interest rate environment plus a trading system failer may be how “the big one starts”?
Consider the concentration risk of a US index, many of whose constituents are dwarfed by the vast market capitalisations of the FANGS. What about the herd risk of funds all selling at the same time? The rise of index funds has spurred the bull market for long enough. Now they will magnify the downturn. The use of stop-loss orders by individual investors is likely to exacerbate the impact. According to an analysis by Schroders — an active manager — the shift to passive investment has coincided with more correlation between stocks and, when those correlated markets start to move, more volatility. Standard passive funds will not act as a brake on a market in nosedive mode.
Vanguard’s and Blackrock’s many fans dismiss the passive doubters and the technology problems (even though there were similar issues during February’s market slump). But for critics of this rapidly growing passive asset managers, the danger is that one way or another one of the world’s biggest asset managers may be at the cause and leader of the next market downturn.