- Passively managed funds do offer the lowest fees but invest in stocks without “thinking”.
- High positive net inflows into passively managed funds push large caps higher regardless of fundamentals.
- If non “thinking” investors panic when things turn, large caps will be the worst performers.
Today we are going to discuss two related topics: fees and the general market consequences of passively managed investing funds.
Fees are charged by funds for their services, be it active or passive management. Passively managed funds, which have the lowest fees, merely track an index. Over the last several years a trend has developed toward lower fees and passively managed funds which may also be creating a growing risk that equities are held by “weak” hands. If panic comes, and investors pull their money out, passive fund managers will be forced to sell, creating further market havoc.
We will start by explaining the current situation and trends, and finish with an analysis of what is best for more sophisticated investors.
Current Fees and Trends
In 2015 the average assets-weighted expense ratio was 0.64% for all funds. The expense ratio includes distribution commissions, management, administrative, operating and all other asset-based costs incurred by the fund but it does NOT include transaction fees which are charged directly to the fund’s assets. These transaction fees are not reported and do lower your returns, but if you manage your own portfolio you incur in the same fees so we are not going to account for those.
If we take the current S&P 500 expected average compounded return of 4% and calculate the value of a $100,000 portfolio for the next 30 years with and without fees, the difference comes to a staggering $56,825.
Figure 1: $100,000 portfolio with and without fees. Source: Author’s calculations.
These fees, that at first look innocuous, contribute to a total income for the industry of $88 billion (2014) per year. The good news is that passive funds charge lower fees with an average of 0.2%, but they still charge a fee and offer only market-like performance, minus fees.
Figure 2: Asset-weighted expense ratios. Source: Morningstar.
The low fees and strong marketing, and the fact that active management has significantly underperformed over the last several years, has attracted lots of capital inflows into passively managed funds. In the past 10 years, the lowest cost quintile funds attracted an aggregate of $3.03 trillion while the other four quintiles attracted only $160 billion. This has several consequences and creates opportunities for the astute investor. In the last 10 years, 18% of actively managed funds did beat their benchmark which means that over-performance can be found if searched for.
Consequences and Opportunities
As 95% of capital flows go into passively managed funds that simply track an index, this also means that 95% of the money in the markets does not “think.” Funds that track an index simply buy stocks according to their weight in an index and continue buying or selling in relation to their inflows or outflows. As passively managed funds have had constant positive net inflows, the stocks with the largest weights in an index will get the most funds and their share price will grow even higher.
Figure 3: Net inflows by expense ratio (lowest quintile are passively managed funds). Source: Morningstar.
The consequence of so much money going into passively managed funds is that the stocks with the largest weights will go up regardless of their fundamentals. If we check the performance of the top 10 S&P 500 constituents, we will see that their stock prices have gone up in the last 10 years. Of the top 10 (all excluding dividends), the best performer in the last 10 years was Amazon with a 2,318% return, followed by Apple with a 931% return and Facebook with a 311% return. The worst 3 stocks were General Electric with a negative return of -3%, AT&T with a return of 37% and Exxon Mobile with a 38% return.
The interesting thing is that only AAPL had returns lower than its revenue and earnings per share growth. All the other stocks have seen their prices increase at a much higher rate than their fundamentals. The high net inflows in passive funds pushed the largest weighted stocks higher since passive funds buy regardless of the underlying fundamentals.
Over the same time period the S&P 500 only grew by 66.62%, which is much lower than the above averages. This proves another important point: passively managed funds are forced to have their largest weighting in companies when their share price is at or near a high point and completely skip being invested during the growth period. As a good example, Facebook had its IPO in May 2012 but was only included in the S&P 500 in December 2013 when its stock was already 100% up since the IPO.
Fees should be assessed constantly since high fees are severely damaging to portfolio returns in the long run as they limit the magic of compounding.
One solution is passively managed investment funds that replicate an index performance, minus a small fee. A fee nonetheless, which should still be considered, especially since passively managed funds do not “think” when buying the biggest companies which proportionately constitute the largest weighting in their portfolios. Furthermore, their growth in share price has less to do with strong revenue and earnings growth, and more to do with a passively managed investing trend that attracts lots of capital.
But what happens when the tide eventually turns? A halt in net flows into passively managed funds would force them to sell assets. And since the current net inflows are much higher than those in 2007, the downside risk is also much higher.
Until a recession hits the economy, why fight the trend when you can outperform the S&P 500 by just following the biggest companies of the index as all the passively managed funds buy stocks according to their weight in an index. However, when a recession comes and people start to panic, the same stocks will see the biggest declines due to forced asset sales in proportion with their weight, and the best option will be to “think” by sticking with companies with the best fundamentals.