It used to be that investors would buy shares directly or place their money with a funds manager, who would select stocks on their behalf.
However, within the past few years the rise of passive investing using exchange-traded 'index-tracking' funds has changed the flow of money in the sharemarket.
Exchange traded funds (ETFs) are transparent, easy to use and cheap. They are bought and sold on the sharemarket, (eg ASX) just like shares. Some track whole markets like the Australian sharemarket or the US sharemarket. Others track the price of particular commodities, others invest with a theme – like investing in only the higher-yielding shares of the Australian sharemarket.
Since the global financial crisis there has been a flow of funds between active funds, cash and ETFs, more recently ETFs have steadily attracted more capital.
The rise in passive investing in the United States is far more pronounced than in Australia. Equity ETF assets have reached $US1.2 trillion ($1.63 trillion), equivalent to one-quarter the size of all US equity mutual funds.
Investment firms that have specialised in index funds have become the largest in the world, with Vanguard swallowing most of the inflow, closely followed by BlackRock and State Street.
Whether stock picking and active management is the best way to invest or whether passive strategies will continue to work is a heavily debated point.
We suggest there’s a case for a combination of both. The “core and satellite” approach, in which ETFs are used to “buy the market” and active management is used sparingly where outperformance is deemed possible.
Investors continuing to follow the trend towards index investing should consider how the rise of 'passive' has changed the nature of the equity markets and consider what they are buying into. By investing in 'passive', you’re assuming risk is adequately priced by the market and you are also taking a larger weighting to the largest companies. Within the broader-based ETFs that invest in the largest companies in the index, the liquidity of the fund is the same as for the underlying asset.
The market’s preference for passive over active will probably ebb and flow. We are in an environment where returns are lower - cash and interest rates are lower - the impact of costs is higher and the focus on costs from a lot of people will be greater. After fees, active managers offering funds at the retail level have on average struggled to outperform the benchmark returns.
There were 117 ETPs at the end of March, up from 102 at the end of 2014. The rise of ETFs has enabled individuals to invest in a way that would have been available only to institutions less than a decade ago.