I have recently finished reading Trillions by FT journalist Robin Wigglesworth. This excellent book chronicles the inexorable rise of so-called ‘passive’ funds and, more recently, exchange traded funds (ETFs).

Unlike ‘active’ funds, passives do not employ fund managers to pick specific investments that they believe will deliver above-average returns. Instead, they identify an index, such the FTSE-100, and then seek to track its performance by investing in each stock in the index according to its size in that index. For this reason they are sometimes known as tracker funds.

According to Wigglesworth’s research, in the year 2000 there was less than $1 trillion invested in index funds and ETFs. Today that figure exceeds $15 trillion.

Proponents of passive investing point to the fact that the majority of fund managers underperform their benchmark index over the medium term. There are at least three reasons for this:
• First, they may simply not be very good at their jobs, being subject to human biases that incline them to make poor decisions
• Secondly, the need to hold cash in their funds means that they suffer an in-built drag on performance
• Finally, active funds charge higher fees which weigh on investor returns.

This final point is key: developments in technology over the last two decades have made using a ‘black box’ to manage asset allocation, rather than humans, markedly cheaper.

But the jury is still out on whether passive always trumps active for investors.

For a start, the majority of active fund managers may underperform…but not all. Just like picking good stocks, the skill may therefore lie in picking good fund managers, monitoring their performance, and knowing when to abandon them.

Equally, passive funds may be well-suited to large and highly liquid markets. But there are many less well-researched areas of the investment world, where information may not be so efficiently shared and opportunities abound for active investment selection. Smaller companies might be one example.

In addition the proliferation of passive funds and ETFs (essentially passive funds that can be traded on a stock exchange like shares), has now led to a situation where the passive industry is starting to undermine its own premise…

With thousands of passive investments available, tracking all manner of ever more precisely defined indices, investors now need to actively select their passive funds.

Furthermore, hybrid funds are now emerging, where machine learning and artificial intelligence are being applied to active fund management. The fund managers of these ‘quantitative funds’ input carefully selected parameters to their black boxes and then let the machines decide on the underlying investment selection.

Finally, by definition, it is impossible for passive funds to exist in an investment vacuum, where there are no active participants in a market.

In conclusion, I think there is room for passive and hybrid funds in investors’ portfolios, particularly when it comes to larger liquid markets. But this is not an either/or situation, and I also believe the demise of the active fund manager has been greatly exaggerated.