Possible Reasons For The Trend Toward Passive Investments

A view of the flow numbers by product type shows that investors around the globe are buying an increasing number of passive products to implement asset allocation decisions in their portfolios. Even as this is often neglected, this trend can become a threat for active managers because the shrinking market share has a negative impact on the profitability of the respective asset managers. But which reasons drive the trend toward passive investments?

Evidence-Based Investing

One of the drivers of this trend is the fact that the internet enables investors to access all kinds of information with regard to possible investments. This means every retail investor can become an educated investor who makes well informed decisions for his portfolio. This alone would not drive the trend toward passive investments. However, there is an increasing amount of research published by market observers, universities, and asset managers that show that the majority of active managers are underperforming their benchmarks. This might lead to investors preferring to invest in these benchmarks/indices instead of an actively managed fund.

Price Matters

The low management fees of passive investment products give them an advantage compared to actively managed products since investors around the globe have become quite cost cautious. This trend was started by institutional investors who demanded low fees for their index-based portfolios. These investors knew that high costs would lead to high underperformance since the return expectation of a passive product is the return of the respective index minus the management fees. The trend toward passive fund products can also be observed by analysing the assets under management in the products and the average management fees. The lower the average fees became, the more money flew into the respective passive products.

Transparency is Key

European investors showed their preference for transparent products during the financial crisis (2008), the euro crisis (2011), and throughout the rough market conditions in 2018. During these periods, actively managed funds faced outflows while ETFs enjoyed healthy inflows. From my point of view, this is explainable by the fact ETFs offer high transparency since they publish all portfolio holdings daily. Conversely, actively managed funds often publish only the top 10 holdings of their portfolio once a month, which makes them kind of a black box for investors. As investors need to know the securities in which they are invested—especially during rough market conditions—to make educated buy or hold decisions on the respective positions in their portfolio, it is not surprising that they prefer passive products over active products. No need to say, but the money that switched from active to passive often does not return to active products.

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