ETFs surge as passive investment overtakes active management in Australia
One of the big trends in Australia – and the rest of the world – has been the triumph of passive investment vehicles such as exchange traded funds over the traditional fund managers and their star stock pickers.
In Australia ASX figures show that ETF investment hit an amazing $200 billion towards the end of 2024.
That represents a 20-fold increase in the last decade and judging by more mature markets such as the US, the surge in ETFs still has a very long way to go.
The reason for that strong growth is not too hard to find.
Passive funds often outperform active managers
ETFs can mimic an index such as the ASX 200 with a high degree of accuracy and with very low costs – a proposition that is very attractive to savvy investors.
Outperforming an index such as the ASX 200 is fiendishly difficult, to such an extent that most fund managers don’t do it in any particular year once accounting for their fees.
That makes ETFs a wonderful way to access the compound growth available from share markets while keeping fees very low.
That also makes ETFs a great investment strategy for millennials who may feel priced out of the housing market but are keen to invest in an alternative that offers capital growth.
Active managers struggling
The other side of this coin, of course, is that active managers have been having a very difficult time of it.
Much of the potential fund inflows are now diverted to passive funds like ETFs, with many big super funds using passive strategies for part of their investments and also internalising much of their fund management.
That has seen the amount of funds under management falling sharply, along with the share prices of many of the listed fund managers.
Share prices tell the story
Just take a look at the share price graphs of Perpetual (ASX: PPT), Platinum Asset Management (ASX PTM) and Magellan Financial Group (ASX: MFG) and you can see the familiar story, combined with individual company mistakes.
It is not a universal story, thankfully, with some smaller fund managers such as GQG Partners (ASX: GQG) and Pinnacle (ASX: PNI) finding small niches in which they can perform well.
Insignia Financial (ASX: IFL) has also performed well and is being pursued by multiple potential suitors and even one of the lazy old giants of funds management, albeit greatly diminished nowadays, has performed much better on the share market AMP (ASX: AMP).
Listed investment companies still offering an alternative
It should also be remembered that some substantial listed investment companies such as Australian Foundation Investment (ASX: AFI), Argo (ASX: ARG) and Washington H Soul Pattinson (ASX: SOL) also offer excellent and relatively low-cost active exposure to Australian shares and have well regarded active investment teams, as do some smaller listed investment companies.
Still, the trend towards passive investment is undeniable and most of the successful fund managers have moved into profitable niches rather than simply offering long only exposure to Australian or international shares.
Investment fees shrinking
To survive, fund managers have also been forced to offer competitive fees which are much lower than the industry grew accustomed to in the “bad” old uncompetitive days when AMP and National Mutual were investment giants charging hefty trailing commissions.
That has forced them into greatly reducing their cost base and improving their efficiency, which is obviously a good thing for investors.
The traditional concept of promoting “star” stock pickers whose words of wisdom showed us why they were smarter and better than mere mortals at playing the share market has also been made redundant by the fact that passive ETF strategies often consistently outperformed these stock picking heroes over time.
The reason why they outperformed and continue to outperform is that it is very difficult to beat the basic ETF index strategy, which buys more of the winning shares according to their size and automatically sells down shrinking companies.
Active managers try to point to different market conditions that suit their particular investment style but even if these claims are true, the duration of the outperformance may be limited.
A difficult year for active managers
The past year was a great example of the difficulties facing active managers.
The strong outperformance of the banks in general and Commonwealth Bank (ASX: CBA) in particular – an outperformance for which finding a logical explanation is very difficult – led to a lot of frustrated active fund managers were quite justified in underperforming a market index that was responding more to the weight of money than rising earnings.
There are some negative consequences to the rise of passive investment, the main one being the lack of involvement in privately and publicly pushing companies and management to achieve better returns.
The big Australian super funds in some cases are trying to replace this role, although they tend to do so on set issues such as female executive numbers or environmental performance rather than pushing hard to improve corporate returns through mergers or other corporate actions.
In some ways passive investment strategies are “dumb” and predictable, buying more shares in companies simply because they have entered an index.
This predictability has led to some active funds trading around these predictable outcomes to achieve trading profits.
It is perhaps in identifying and profiting from the “dumb” actions of passive funds that active managers can find at least one other way in which to survive and thrive in an increasingly competitive investment environment.