Pro Analysis

Santoli: Passive investing boom accelerates in '16

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Choosing an index fund means venturing no view on which stocks might do better or worse than the market. Yet the powerful trend toward passive investing certainly triggers passionate opinions about whether it is good or bad for markets, the fund industry and investors.

There can be little disagreement about how pronounced the mass migration to indexing strategies has become. Since 2009, some $961 billion in net new money has entered index-tracking mutual funds and exchange-traded funds, according to Bank of America Merrill Lynch. Over the same span, about $600 billion has exited actively managed funds, which seek to outperform a benchmark.

The shift has accelerated this year, with $200 billion in outflows from active stock-picking funds and more than $160 billion into passive vehicles, based on Morningstar data. Equity-index funds hold some $2 trillion, while index funds across all asset classes account for a third of all assets run by the investment-management industry.

Personal-finance experts (and their adherents in the financial media) celebrate this trend the way nutritionists would applaud if most people shunned junk food and adopted a sensible diet-and-exercise regimen. The futility of selecting fund managers likely to outperform over time and the low cost and tax efficiency of indexing have been preached for decades.

Now, after two devastating bear markets and a long bull-market advance in which active managers have continued to struggle, the investing public has flocked to this logic.

The rise of efficient ETFs and the "robo-advisor" services that use them to run inexpensive portfolios give indexing a wised-up, modern feel – like a true technological innovation rather than simply one among many approaches to accruing wealth.

Or has the pendulum of financial fashion simply swung far in the direction of passive investing? It's true that simply "buying the market" through the biggest index stocks tends to seem like a no-brainer the longer and higher a bull market runs. It happened with index funds bought by faithful 401(k) investors in the late-'90s and before that the Nifty Fifty mega-cap stocks that were deemed worthy of buying and never selling in the early 1970s.

Yardeni Research points out that stock-picking and passive funds' relative performance tends to be cyclical over long periods. And active management tends to come back in favor during bear markets or panics, when owning a full complement of stocks according to their weight in an index can come to seem like a penny-wise/pound-foolish approach for a while.

Hartford Funds research points out that in the 21 stock-market corrections since 1987, active managers outperformed the market more than three-quarters of the time (probably due to holding some cash and some more defensive positions).

It's hard to argue broadly with retail investors opting for low-cost market exposure over the dream of outmaneuvering a mercilessly competitive stock market. But the fact that indexing has been on a strong run outpacing active management means this trend could simply be a matter of performance-chasing disguised as virtue.

For many veteran market observers, the irresistible question is whether, and how, the lopsided preference for passivity is creating anomalies in how the market acts – and whether they can be exploited somehow.

Some quantitative work does hint that stocks today move together as a group more than they used to as index-level supply and demand outweighs stock-specific forces. Technical analysts note that, for instance, on up days the advance-decline split within the S&P 500 is often stronger than for the overall market, suggesting index ETFs and the like leading stocks around.

Bill Ackman of hedge fund Pershing Square Capital suggested early this year – in an investor letter partly aimed at explaining his poor 2015 performance – an "index bubble" is building. More money sluicing toward the biggest index stocks can bloat their valuations and active managers feel compelled to shadow the indexes, he claimed.

Yet top S&P 500 stocks Apple, Microsoft and Exxon Mobil don't appear notably more stoutly valued than comparable companies with smaller index weights.

A more positive spin offered by anti-indexers suggests that when all the money is going to funds that don't try to find neglected or more attractive stocks, then those who do try should have an easier time of it.

With active equity firms burdened with steady cash outflows, they have fewer resources to unearth fresh ideas. And the Wall Street firms who cater to them get less business, so research budgets are cut back.

Could the belief in efficient markets that supports passive indexing actually become so popular that it makes markets less efficient and more "beatable?"