Passive Investment Funds Leading the Way (Assessed Blog 3)

The Vanguard Group is a privately owned investment manager. The firm primarily provides its services to investment companies. They invest in public equity and fixed income markets across the globe and employ a combination of fundamental and quantitative analysis to create their portfolios (Bloomberg, 2015). It was announced on the 1st March 2015 that the company has recorded the highest net fund flows in the industry at a staggering $291bn (Financial times, 2015). The company adopts a passive investment technique and is currently outperforming its peers significantly, especially those adopting an active fund strategy, for example Pimco that has an estimated net outflow of $175bn!

Figure 1: A chart to show how companies adopting passive investment techniques are outperforming their rivals

Source: Financial Times (2015)

The companies that are highlighted in green are those investment companies that deploy a passive investment fund strategy and those filled red adopt an active strategy. From the chart, we can see that those highlighted in green (those adopting a passive fund management technique) are clearly outperforming their competitors who actively manage their funds. 

It is not coincidental that Vanguard’s passive investment fund has generated higher net funds than companies like Pimco. Other large passive investment fund providers such as BlackRock and State Street Global Advisers also attracted billions of dollars in new business last year. BlackRock enjoyed $178bn in estimated net inflows, the second-best performer, and State Street attracted $42bn in new business, the fifth-best performer.

Vanguard’s popularity and Pimco’s problems highlight the growing popularity of passive investment funds, which track an index and charge much lower fees than active investment funds. Vanguard has $2tn in tracker funds and $450bn in global exchange traded funds, making it one of the world’s biggest providers of these products (Financial Times, 2015). Pimco, on the other hand, use an active technique, which aims to select investments that outperform the broader market. Outperforming the market is much more difficult to do, as it is a zero-sum game. In addition depending upon the efficiency of the market (Fama, 1970), this is said to be extremely difficult because in a perfectly efficient market, only a privileged few will have the skill to outperform and spot inefficiencies that are big enough to profit from (Financial times, 2011).

Tim Buckley the chief investment officer at Vanguard attributed the company’s success to relentlessly cutting fees. Active fund managers find it difficult to compete with passive investment funds like Vanguard’s because of the high fees associated with active funds, which is why many active funds under-perform the market. These high fees have been compared to “paying someone to toss a coin” (Watson & head, 2013, p. 48). Thus, active management is claimed to be a wealth destroyer rather than maximiser. In addition, Vanguard is able to reduce their cost due to their sheer scale and unique ownership structure stating “Investors can’t control the markets, but they can control the costs of investing” (Vanguard, 2015, para. 5).

If we refer back to Vignette 2.2 in Watson and Head (2014, p. 47), the third seminar discussion was heavily revolved around whether it is better to hold an active or passive fund. Is it  better to hold an active fund, where the weight of the portfolio was changed a lot, or  was it better to hold a passive fund, which remained unaltered for a much longer period of time. Cremers & Petajisto (2009) find that funds with the highest Active Share significantly outperform their benchmarks both before and after expenses, and they exhibit strong performance persistence. Non-index funds with the lowest Active Share under-perform their benchmarks. In reality however, this in not always true, this is evident at the present time. Passive funds are currently outperforming active funds

It has long been debated as to which investment strategy is best, consistency is a major concern, just because passive investment fund companies are doing well currently, this does not mean they will continue to be ahead of their competitors in the long run. If we refer to Newton’s third law of motion, every out-performer requires an equal opposite under-performer. I believe that although passive funds are becoming more popular at this present time, this will be a short term trend and it won’t be long before active funds start to generate more wealth.

References

Bloomberg (2015). Company Overview of the Vanguard Group, Inc. Retrieved 01 March 2015, from http://www.bloomberg.com/research/stocks/private/snapshot.asp?privcapId=417222

Cremers, K. J. M., & Petajisto, A. (2009). How active is your fund manager?: A new measure that predicts performance. The Review of Financial Studies, 22(9), 3329-3365. doi:10.1093/rfs/hhp057

Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. The Journal of Finance, 25(2), 383-417. doi:10.1111/j.1540-6261.1970.tb00518.x

Financial Times (2015). Vanguard tops mutual fund survey with $291bn in new business. Retrieved 01 March 2015, from http://www.ft.com/cms/s/0/55b87a46-be96-11e4-a341-00144feab7de.html?siteedition=uk#axzz3TJNAA1SW

Financial Times (2011). Chasing the elusive alpha.   Retrieved 01 March 2015, from http://www.ft.com/cms/s/0/e9433bec-6207-11e0-8ee4-00144feab49a.html#axzz3TKnKvq3d

Vanguard (2015). A low-cost investment leader that puts clients first. Retrieved 01 March 2015, from https://www.vanguard.co.uk/uk/portal/about-vanguard/about-us

Watson, D., & Head, A. (2013). Corporate finance: Principles and practice. (6^th Ed.), New York: Pearson