Passive Index Funds | Adviser Investments

Passive Index Funds: More Popular—But Getting More Complicated

At the beginning, the promise of passive funds was simple: Match the market’s performance, beat active managers on price.

Starting in the 1970s with Vanguard’s pioneering index funds and boosted in recent decades by the surge of flows into exchange-traded funds (ETFs), so-called “passive” investing strategies have been on a slow rise toward industry dominance: Last year, investors added $695 billion in assets to passive funds’ books, while withdrawing $85 billion from active funds, according to Morningstar. By April 2019, passive funds made up over 35% of assets invested in U.S. equities—up from less than 20% at the end of 2008. Based on flows last year, that trend could continue.

Note: Chart shows overall percentage of assets in Morningstar’s “U.S. Equity Fund” category invested in passive open-end funds from 12/31/08 through 4/30/19. Source: Morningstar Direct.

As passive funds have gotten more popular, however, they’ve also become more complicated, often in ways that go unnoticed by investors.

What’s driving the change? In large part, it’s a question of fees. The lower fees offered by passive funds in comparison to traditionally managed active funds have drawn huge numbers of investors. Big fund companies, including Vanguard, Fidelity and Schwab, have engaged in a race-to-the-bottom price war that Fidelity may have “won” late last year with its launch of zero-fee index funds.

What’s a fund company to do when it needs to cut its own costs to the bone to support lower fees? Well, in some cases, start tinkering under the hood of the simple index fund. Specifically, many funds are beginning to use custom-built indexes to track the markets instead of relying on those provided by name-brand index shops like Standard & Poor’s, Russell or MSCI.

The reason is simple: Those big index brands charge fund companies licensing fees to use one of their indexes as a benchmark. By building a custom index in-house, fund firms can avoid those costs—in fact, that’s precisely what Fidelity did in launching its zero-fee funds.

Should that matter to the average investor? Perhaps not when it comes to large-cap U.S. equities: The names in the S&P 500 index and Fidelity’s U.S. Large Cap Index fund are essentially identical, since they are built nearly the same way using a relatively small universe of stocks.

Differences start to pile up when comparing funds that track small- and mid-cap companies, or global equites, where slight variations in how stocks are picked may mean one fund company’s index includes dozens or hundreds of stocks another’s doesn’t. The more tweaks a fund company makes to its index, the more likely that the performance of its fund falls out of step with the sector it’s supposedly mimicking.

Many fund companies are now leaning even further into the power of custom-building indexes in order to differentiate themselves in a crowded sector. So-called “smart beta” index funds or “quant” funds use a variety of strategies to build out their indexes, such as overweighting a particular sector or factor relative to the index, with the intention of reaping increased returns. Such strategies have seen growth in recent years, with assets under management in the U.S. rising from less than $100 billion in 2009 to $705 billion by December of last year, according to Morningstar.

Though such strategies are often called passive because of their use of indexes, they often behave more like actively managed funds (and some have the fees to match). Last August, the SEC and FINRA released coordinated investor bulletins, with both regulatory agencies warning investors to be aware of the heightened risks of such “passive” strategies.

Here at Adviser Investments, we think passive investment strategies can play a role in a portfolio. If you’re looking for a broadly diversified fund, a low-fee index or ETF may be your best bet. But as our previous examination of another custom fund, the Schwab 1000 Index, revealed, “custom” doesn’t necessarily mean better—and a low fee won’t be able to hide a lesser strategy’s flaws for long.

When we determine that passive strategies are appropriate for a particular client’s needs, we apply our Active Acumen analysis to create an index-based portfolio that reflects the asset allocation decisions of the select group of active mutual fund managers we invest with.

While the average active manager might not be much to write home about, the right active manager can make a profound and positive difference in your portfolio. That’s why we spend the time researching them, talking to them, observing them and, when we have conviction in their abilities, investing with them—right alongside our clients.

This material is distributed for informational purposes only. The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations or personal investment advice, or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed.

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