Small investors’ move to ‘passive’ stock funds becomes a stampede

Whenever small investors have been pitched a financial product that promised to enrich them with little effort or expense, historically the smart response has been to turn and run.

There has been one shining exception over the last four decades: low-cost mutual funds that aim to do nothing more, or less, than generate the average return of the entire stock market, or a specific market sector.

These “passively managed” or “index” funds have delivered as they said they would — and have shamed many “actively managed” U.S. stock funds, the majority of which over the long run have failed to exceed or match the average market return after deducting their fees.

Passive funds were relatively slow to catch on with individual investors in the 1980s and ’90s. But over the last few years, Americans have poured record sums into the funds, including those that replicate the Standard & Poor’s index of 500 big-name U.S. stocks. In that same period, investors have yanked record amounts from actively managed funds.

The result: Conventional U.S. stock mutual funds that invest passively now hold $1.9 trillion in assets, triple what they had in 2007. Add in the $1.7 trillion in U.S. equity exchange-traded funds, another type of index portfolio, and the total in passive funds accounts for 42% of all U.S. stock fund assets — up dramatically from 24% in 2010 and just 12% in 2000.

The explosion in passive funds’ growth has left some of its devotees almost giddy.

Mark Hebner, who founded Index Fund Advisors in 1999, has made it his life’s work to persuade people “what a fool’s errand it is to try and beat the market.” His Irvine company devises portfolios of passive stock funds for investors.

“Imagine my joy after 18 years at this,” Hebner said. “It’s finally sinking in with investors.” His firm directs $3 billion in client funds.

At index fund titan Vanguard Group, total investor assets topped $4 trillion this year. Investors sent Vanguard’s stock and bond funds an astounding $277 billion in new money in 2016. Most of its major fund rivals, including Fidelity Investments, Franklin Templeton Investments and the American Funds, saw net cash outflows as more investors sold than bought.

“Passive investing has seized the high ground, and it ain’t giving it back,” said Russ Kinnel, director of fund manager research at Morningstar Inc. in Chicago.

But even as small investors reap the many benefits of indexing, the passive-fund juggernaut also is raising concerns. Some experts liken it to a new market bubble as investors pile on with U.S. stocks at record highs after an eight-year bull run.

Much of the migration to index funds has been led by fee-only investment advisors, such as Hebner, who have embraced the idea of using low-cost passive funds to build diversified portfolios for individual investors. The rise of automated “robo-advisors” also has boosted demand for passive funds.

The advisor’s investing style then becomes the “active” portfolio component, said Brian Reid, chief economist at the Investment Company Institute, mutual funds’ trade group. How advisors pick index funds, and how often they alter the lineup of funds, will determine the portfolio’s performance — for better or worse.

“It’s a shift from the mutual fund providing the active management to the advisor providing it,” Reid said.

The passive fund industry is betting that many more individuals will be drawn to that simplicity in portfolio construction. That might include Jim Quinn, a 76-year-old Palos Verde Estates retiree who has long owned well-regarded actively managed funds including Oakmark Select and Dodge & Cox Stock.

Would he consider moving everything to passive funds? “I’ve definitely thought about it,” Quinn said. His current stock strategy is “dabbling here and there,” he said.

But as the passive fund business balloons, it raises risks for the stock market that many small investors may not understand:

• Passive investing makes the market less efficient — meaning, less “honest.” This concern is rooted in the very nature of passive funds: They buy stocks without considering the fundamentals.

In classic financial theory the market sets the “correct” price for a stock at any given moment based on the buy and sell decisions of informed investors. But when money flows into conventional index funds, they must buy the stocks in their index regardless of the underlying companies’ financial health or outlook.

“Of course it distorts things,” said Rob Arnott, who has pioneered a fundamentals-based form of indexing at Research Affiliates in Newport Beach. “Price discovery,” the term for research that gets to the heart of a stock’s relative value, “is diminished as fewer and fewer investors care about the fundamentals,” Arnott said.

Yet he and other experts doubt that the rise of passive investing has seriously undermined market efficiency. The U.S. stock market is worth $26 trillion, but only about 25% of that is owned by passive funds, Vanguard estimates. The rest is controlled by active managers at mutual funds, pension funds, banks and other institutions, or is in the hands of individuals.

Joseph Brennan, global head of equity indexing at Vanguard, said “there may be a theoretical limit” to how large passive investing can get before compromising the free-market pricing mechanism. “But it’s probably closer to 80%,” he said. “It’s certainly well north of 50%.”

• Passive investing inflates already-hot market sectors. Most major stock indexes, including the S&P 500, are “capitalization weighted.” So the greater a stock’s market value, the more influence it has over the index’s moves. It also means that, as cash pours into index funds, the funds must invest most heavily in the stocks that already are the market’s largest names.

Today that means shares of tech stars such as Amazon, Apple and Facebook.

Index giants such as Vanguard don’t dispute this. But they argue that the point of passive investing is to own the market as is — not to judge it.

Inigo Fraser-Jenkins, a market strategist at investment firm Sanford C. Bernstein, caused a stir on Wall Street last year after writing a report calling passive investing “worse than Marxism” because it can steer investment away from important new ideas.

Arnott in 2005 developed his own style of indexing to compete with capitalization-weighted indexing. Known as RAFI, for Research Affiliates Fundamental Index, the system weights stocks by certain standards, such as companies’ sales growth and net worth. The goal: Keep the index focused on stocks that are judged to be values.

“To succeed in investing you have to buy what others fear and loathe,” Arnott said. The idea behind RAFI “is to trade against the market’s biggest bets” to focus on what’s unloved. About $130 billion in fund assets index using RAFI rules.

Hebner’s company invests via the mutual funds of Dimensional Fund Advisors, an index fund manager that also favors the idea of trying to tilt toward value. Dimensional oversees about $460 billion in assets.

But to index purists, any system that is biased against the market’s biggest companies is trying to beat the market — and therefore isn’t passive.

• Passive investing could be a bubble that will eventually pop. This is perhaps index investors’ worst fear, though not necessarily Wall Street’s fear: Could the recent torrent of cash into index funds suddenly reverse?

Index investing has been an increasingly easy choice since 2009, because most major stock gauges have been rising with few interruptions. If many investors who have poured into index funds have been chasing performance, what will they do if the big gains stop?

Passive investing is marketed as a long-term, buy-and-hold strategy. But Hebner acknowledges that “it’s so hard to get people to let go of the gambling mentality.” If their investments turn cold, it’s human nature for people to want to shift money to what’s hot.

Because the S&P 500 has posted such strong returns since 2009, and because stock prices relative to earnings are historically very high, many Wall Street pros expect the index to struggle over the next five to 10 years.

That could give actively managed funds a chance to woo investors back, if the funds can show better stock-picking prowess. “There is a natural equilibrium,” said Salim Ramji, head of U.S. wealth advisory at fund titan BlackRock Inc. “As more money moves to indexing, there should be more ways for active managers to add value” and beat indexes.

Dan Wiener, head of Newton, Mass.-based Adviser Investments, which manages $4 billion in mutual fund accounts for clients, said that “any time you have losses or low returns in the indexes, people are going to start looking at active.”

The next severe bear market will test new index investors’ pain threshold, Wiener said. He notes that the S&P 500 lost nearly 57% in the 2007-09 bear market, and index fund managers didn’t intervene to lessen the decline — because that isn’t their job. They expected investors to ride it out.

It’s a reminder, Wiener said, that “if you think indexing is a panacea, you’ve got another thing coming.”

business@latimes.com