Why the Rise of Index Investing Isn’t Slowing Down Anytime Soon

On this episode of The Long View, Bryan Armour, director of passive investment strategies research, North America, for Morningstar Research Services and editor of the Morningstar ETFInvestor newsletter discusses index investing, fund flows, bitcoin ETFs, and more.

Here are a few excerpts from Armour’s conversation with Christine Benz and Dan Lefkovitz.

Could Anything Slow the Rise of Index Investing?

Dan Lefkovitz: We wanted to start with a major milestone that we hit recently in the US market: the fact that passive strategies now account for the majority of assets in funds and ETFs, and on a global basis, passive share is about 40%. Our colleague, John Rekenthaler, recently wrote that index funds have officially won. Do you see anything that could slow the rise of index investing?

Bryan Armour: It’s a runaway freight train right now. But no, it’s been a long, persistent trend. And I think the real reason why it’s done so well is because of the cost story. Passive investing comes with lower fees, lower trading costs, and greater tax efficiency. That’s going to be hard for active managers to beat consistently because they have to beat passive on a gross basis and then by more than the difference in their fees as well.

To take a step back, indexes are concentrated right now—market-cap-weighted indexes. And so, I think the S&P 500 has the highest concentration in the top 10 holdings in the past 50-some years. And so there is an opportunity for active investors, I think. And you have these zombie flows that are coming from passives where it’s like savings come in and just go out to the market where active managers could really find an advantage. A rough stretch for cap-weighted indexes might not be enough to move passives off the mark. But the best chance for active managers to get back on top is to cut costs and take away passives’ superpower.

The Shift From Active to Passive Management

Christine Benz: We want to delve into some of those themes and some of the performance trends that you and the team have observed. But sticking with fund flows: It had been the case that investors preferred actively managed fixed-income funds, but even that seems to have shifted toward passive over the past several years. Can you talk about that? Because it seems like the fundamental case for an active strategy in fixed income is stronger than the case for equities, but maybe you can delve into that and what you’re seeing in terms of flows.

Armour: If you draw a straight line, it’s from active mutual funds, going out of active mutual funds into passive ETFs. And it’s generally true across the board for fixed income, equity, and so on. It does make the most sense, I think, to go passive in the areas where there’s the richest information embedded in prices of stocks, for example, or US Treasuries as a fixed-income example. Large-blend-style funds, those types of stocks have the widest coverage and the fastest reaction to changes in information about the companies. So, they tend to be priced very well, and passives can really free-ride that pricing by active managers and kick it back to investors for a lower cost. How do you index the bond market? If you go by market weighting, then you end up investing the most in the most indebted issuers. In some cases, for core bonds, for things like Treasuries—a very liquid market. Those are fit for passive investing. And if you look at an aggregate bond fund, a huge chunk of the aggregate right now is Treasuries. But something like muni bonds, for example, there is some inefficiency in selecting munis. They’re not taking part in the issuance. To some extent, they might get some of the leftovers. But just in general, it’s easier for investors to understand what a passive fund is going to do. And those expectations and low fees are a good fit for most people.

Advisors, Model Portfolios, and Fund Flows

Lefkovitz: It seems like a lot of advisors these days might be ETF-only. You’ve written about models as well, model portfolios. What role are they playing in flows?

Armour: There’s been a shift in distribution in that sense, where advisors are moving to fee-based advice instead of commission-based. And what that means for investors is that they’re going to push toward cheaper funds, which often means ETFs or index mutual funds. And then if they do go active, ETFs are growing a menu. We’ve seen model portfolios come as a really good option for advisors where they can just follow the script rather than spending too much time with asset allocation. And so, a model portfolio gives you the full portfolio, all the ETFs that you can invest in to follow the model. And it’s been a really good tool for investors, and it’s pushed some flows around, too. We just had the Model Flows Landscape report come out recently from Manager Research here at Morningstar. And model portfolios are growing extremely fast. IShares, for example, has one of the biggest model portfolios. They work closely with advisors to help them understand the changes that they’re making and give them performance attribution analysis to pass on to clients. But last March, they shifted from their iShares ESG Aware ETF ESGU to their Quality Factor ETF QUAL. And that led to a $5 billion outflow from ESGU into QUAL. It’s having some pretty significant ramifications in the market.

Vanguard, BlackRock, and State Street

Benz: Let’s talk about providers and what you’re seeing in terms of flows. It seems like the big three—Vanguard, BlackRock, State Street—have grown market share, but maybe you could just talk about that, how the spoils do seem to be going to fewer firms.

Armour: The biggest have gotten bigger. I would even say that Vanguard and iShares are in their own tier now, and then State Street is alone in that next tier. But a lot of it has been scale. It’s been being able to scale their operations, scale their strategies, and offer them for low costs, which then puts pressure on others to catch up. We’re at a point where Vanguard might actually catch iShares soon. They’ve been winning the flows battle for the past few years. But there are two ways that assets can increase. One is new flows, net investment, and the other is the performance of the existing assets. So, Vanguard does have a little bit more of a tilt toward equity assets, which means they could be boosted by a strong stock market and take over as the top ETF provider. And then in the active ETF space, there’s been a shift in the largest providers. Dimensional converted their first mutual fund to an ETF about three years ago, and they’ve already taken over as the largest issuer in the active ETF space. And then options-based strategies have been a huge growth engine of active ETFs, and J.P. Morgan has really benefited from that.