Abnormal Returns is on hiatus this week. However that does not mean that we are content-free. As we did last year, and the year before, we asked a panel of independent finance bloggers a series of (hopefully) provocative questions. We hope you enjoy these posts as much as we do putting them together. Feel free to jump in the comments with your own answers to the questions.
Question: This post argues that John Bogle, i.e. low-cost indexing, has already won. Has he? What comes next? (Answers in no particular order.)
David Merkel, Aleph Blog, @alephblog: No, Jack Bogle has not won yet, and I think he would agree with me. ETFs for the most part have low costs, but from my limited observations they lose in a bigger way than fees. People using them to aggressively trade end up losing far more than the difference in fees. Those in open-end mutual funds trade far less, and lose less as a result. We need to look at dollar-weighted returns, not time-weighted returns. ETFs lose more than a buy-and-hold investor would experience.
Brian Lund, bclund, @bclund: Yes. What is next is the total and final destruction of the broker model and a move towards “co-directed” investing, where the customers leverages the experience of an seasoned market participant to trade/invest.
Tom Brakke, tjb research, @researchpuzzler: Given the predominance of active management, it is hard to say that Bogle has won, but at the margin he is clearly winning. As I noted in a recent piece on the investment management industry, active managers now have to step up, by offering truly differentiated methods and results (no more closet indexing, or playing the game in a way that effectively results in that), and, yes, lowering fees.
Bill Luby, VIX and More, @VIXandMore: There is a general downward trend in all fees related to the investment world, as more firms are forced to compete on cost and as more investors become comfortable with a self-directed approach. Index funds were the leaders in the area of low fees, with actively managed funds sticking more stubbornly to higher fees. No load mutual funds began the revolution and more recently brokers have extended this war on fees to include commission-free exchange-traded products. Asset management fees are also trending lower for both hedge funds and registered investment advisors.
With continued advances in technology as well as the breadth and depth of information available to retail investors, the rise of the self-directed investor should continue, but the size of this market segment has a limit, as many investors do not have the time, inclination, knowledge and confidence in their own ability to manage their investments. Eventually, I see three customer segments being defined in a more distinct manner: (1) self-directed investors; (2) investors who partner with an investment manager; and (3) investors who outsource the investment management process and often also the emotional and intellectual component of managing their assets.
Investors with a higher sensitivity to price and costs (particularly self-directed investors) will place a strong emphasis on cost and that should keep fees trending down. There will be pockets where fees will be stickier, particularly those in alternative asset classes, complex strategies or more specialized areas of focus. Ultimately, the ability to add value through a targeted focus or in dealing with increased complexity will be a requirement for maintaining higher fees, but the trend in this direction may be slow as short-term and intermediate-term performance and correlation data make it difficult to draw conclusions about the long-term value of these investment approaches.
Along the way, I expect that the trend toward ETPs and away from mutual funds will pick up steam. ETPs that embrace the index fund approach will continue to lead the way, but the rise of actively-managed ETPs will begin to undermine mutual funds more dramatically going forward. Whether investors continue to embrace an index-based approach or seek out active management products in an effort to beat the indices, it is just a matter of time before ETPs nudge aside mutual funds and rule the financial world.
Jared Woodard, Condor Options, @condoroptions: How many 40-something professionals still pick stocks? Bogle has definitely won, in that sense. People hate high fees, complex strategies, and hedge funds so much that they’d rather take cheap beta than reach for any alpha. What comes next is a quiet resurgence of alpha opportunities for smart managers.
Wesley R. Gray, Ph.D., TurnkeyAnalyst & Empiritrage, @turnkeyanalyst & @empiritrage: There are few broad category descriptions in my mind: passive, closet-passive, and active. Passive would be the S&P 500 index, closet-passive would be “active” managers that have very little tracking error, and then there are genuine active managers that have more concentrated portfolios and are less concerned about tracking a passive benchmark (i.e., rare).
Bogle has certainly won the hearts and minds of the passive and closet-passive investors, as evidenced by fund flows and the data on the performance of active managers relative to passive benchmarks. That said, there are still large pools of capital allocated to genuine “active” managers via mutual funds and other asset structures (hedge funds, SMA, and so forth). The next revolution will be transitioning these high-tracking error active portfolios into lower-cost and tax-efficient ETFs. Our firm is creating an active ETF platform to facilitate Vanguard 2.0 and transition the high-tracking error, high-cost active strategies into low-cost, low-tax drag investment vehicles. We’re excited about changing the industry.
Josh Brown, The Reformed Broker, @reformedbroker: What comes next, hilariously, is a flat market where the index does nothing – once the last investment dollar is the world is finally thrown at a passive product. That’s when alpha strategies begin to gain some traction again – precisely when no one is in them. This will, of course, frustrate the maximum amount of participants which is what the market has been designed to do.
Look for a boom as the pendulum swings back in hedge fund strategies adopting the mutual fund/ETF wrapper and other so-called “Liquid Alts” coming out. They will have dramatically lower fees than these strategies typically have had in their hedge fund lives. Bogle will end up “winning” all over again as the bulk of these disappoint circa 2015, 2017. Then we’ll all go back to indexing.
I can see for miles and miles.
Michael Kitces, Nerd’s Eye View & Pinnacle Advisory Group, @MichaelKitces: The caveat that this article misses is the rise of tactical asset allocation, overlay managers, and other portfolio management approaches that use passive pooled vehicles (e.g., ETFs) as a tool to implement what are actually active strategies (and for which there’s a separate active fee). Cerulli’s research notes that ETF managed portfolio providers are “flourishing” (see http://www.financial-planning.com/news/advisors-to-ramp-up-etf-allocations-cerulli-2685079-1.html). You can believe that that trend is good or bad, but to say the least it’s not exactly the buy-and-hold indexing focus of Bogle, and suggestions that the growth of ETF index funds mean Bogle has won miss the point of how ETFs are being used by a large segment of investors. There’s a difference between the passive vs active debate – a la Bogle – and the strategic versus tactical implementation, which can be done with active OR passive funds, as I wrote a few years ago (see http://www.kitces.com/blog/archives/103-Is-The-Passive-Vs-Active-Debate-Different-Than-Strategic-Vs-Tactical.html).
Jeff Carter, Points and Figures, @pointsnfigures: Of course Bogle won. So did David Booth. He used a similar theory and returned billions-they even named the best business school in the world after him. Efficient Market Theory works. You can’t beat the market.
Robert Seawright, Above the Market, @rpseawright: Despite the enormous growth of passive investing, Jack’s arguments have been much more successful within the marketplace of ideas than in the markets themselves. Based upon the supporting data, I have consistently argued that those in the active management business ought to be able to defend their processes with more than just a sales pitch — y’know, with data and stuff. Sadly, that isn’t often attempted much less achieved. While I don’t think that Jack’s argument extends nearly as far as he does (I think that active management is a valuable and appropriate tool), I also think that passive management is the appropriate investment default and that the situations of the majority of individual investors would be improved by their using passively managed investments. I don’t think Jack has won or even that his position is like that of the Allies after D-Day (the outcome seems decided but there is still a lot of work to do). That said, Jack is clearly ahead.
Josh Brown once quipped that the definition of a hedge fund is “a vehicle that turns investor capital into Greenwich real estate.” That’s as relevant to mutual funds as it is hedge funds. The evidence is overwhelming that the vast majority of active managers can’t beat an index, which is actually a certainty given the size of the industry. Their justification of fees is now that they offer risk management and lower volatility, but that’s questionable, too — and no one asked investors if they signed up for such an arrangement.
Active managers can hide during a 1990’s boom when their fund earns 30% while the S&P returns 32%. No one cares about underperformance when they’re still getting rich. But when investors realize they paid a manager 150 basis points a year for a lost decade, they wake up.
Individual investors have gotten the message. The next to move will be company 401(k) administrators. My guess is that ten years from now there will be a third fewer actively managed equity funds, 2-and-20 will become 1-and-5, Vanguard will gain another $1 trillion in AUM above market returns, and most investors will be better off because of it.
Thanks to everyone for their participation. Stay tuned for another question tomorrow.