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Index Investing: It Makes Active Management Better

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Abstract

At the end of 2017, assets invested in US index mutual funds and ETFs topped $6.7 trillion, representing 34.6% of current equity mutual fund assets. Given that they were $11 million in 1975, the growth has been nothing short of phenomenal. And, as if that is not enough, State Street predicts that global ETFs assets could reach $25 trillion by 2025, a $2.2 trillion per year increase. A study by PWC forecasts that active management will represent 60% of global AUM by 2025, down from 71% in 2016, while passive investment will grow from 17% to 25% globally. Despite this growth, it is important to keep in mind that the percentage of the US stock market held in the form of index funds is still low: 13% at the end of 2017. This compares to 16% for active mutual funds and 71% for other investors.

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Notes

  1. 1.

    Bogle, J.C., 2016, The Index Mutual Fund:40 Years of Growth, Change, and Challenge, Financial Analyst Journal,72, 9–13.

  2. 2.

    State Street presentation, Inside ETF conference, January 2017.

  3. 3.

    Asset and Wealth Management Revolution: Embracing Exponential Change, 2017, PWC.

  4. 4.

    2018 Investment Company Fact Book.

  5. 5.

    Bogle, J.C., 1951, The Economic Role of the Investment Company, Princeton University thesis.

  6. 6.

    Markowitz, H., 1952, Portfolio Selection, Journal of Finance, 7, 77–91.

  7. 7.

    Sharpe, W., 1964, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, Journal of Finance, 19, 425–442.

  8. 8.

    Samuelson, P., 1974, Challenge to Judgement, Journal of Portfolio Management, 1, 17–19.

  9. 9.

    It was originally named First Index Investment Trust.

  10. 10.

    How the Index Fund was born, Wall Street Journal commentary, September 2011.

  11. 11.

    Based on the Vanguard 500 Index Fund Factsheet (as of 10/31/2018).

  12. 12.

    Based on the Vanguard SP500 ETF Factsheet (as of 9/30/2018).

  13. 13.

    David and Goliath: Who Wins the Quantitative Battle?, remarks by John C. Bogle at the Q Group, Washington D.C., April 21, 2016.

  14. 14.

    Pedersen, L., 2017, Sharpening the Arithmetic of Active Management, working paper.

  15. 15.

    Sharpe (1991) calls this the arithmetic of active management.

  16. 16.

    Mauboussin, M., Reflections of the Ten Greatest Attributes of Investors, Credit Suisse, 2016.

  17. 17.

    The mid 2018 report shows that over a 15-year period, 92% of US large cap managers (95% of mid-cap and 97% of small cap managers) underperformed their benchmark.

  18. 18.

    http://www.cnbc.com/2017/01/26/greatest-deal-in-financial-history-9-for-a-full-investing-plan.html

  19. 19.

    Pension Acts that generally try to facilitate a shift from Defined Benefit pension systems to Defined Contribution ones.

  20. 20.

    During Email exchanges with one of the author from Cremers et al. (2016) we learned that the sample under analysis is being currently expanded through 2016.

  21. 21.

    We define “stricter” as the combination of an approval value of “2” and a value greater than the average for “judicial”.

  22. 22.

    See Cremers and Petajisto (2009).

  23. 23.

    John C. Bogle, 2016, The Index Mutual Fund: 40 Years of Growth, Change and Challenge, Financial Analyst Journal, January/February 2016.

  24. 24.

    ETFGI research report, 2018.

  25. 25.

    Founder and former Chief Executive of the Vanguard Group.

  26. 26.

    Head of Institutional Investment Strategy at ProShares.

  27. 27.

    John C. Bogle, 2016, The Index Mutual Fund: 40 Years of Growth, Change and Challenge, Financial Analyst Journal, January/February issue.

  28. 28.

    Joanne Hill, 2016, The Evolution and Success of Index Strategies in ETFs, Financial Analyst Journal, September/October issue.

  29. 29.

    Eric Balchunas 2016, The Institutional ETF Toolbox, Bloomberg Financial Series.

  30. 30.

    Eric Balchunas 2016, The Institutional ETF Toolbox, Bloomberg Financial Series.

  31. 31.

    Eric Balchunas 2016, The Institutional ETF Toolbox, Bloomberg Financial Series.

  32. 32.

    Hassine M., and T. Roncally, 2013, Measuring Performance of Exchange Traded Funds.

  33. 33.

    Guggenheim changed the construction methodology in April 2015 and since then it looks a lot more like the Ishares one, E. Balchunas, The Institutional ETF Toolbox, Bloomberg 2016.

  34. 34.

    http://blog.alphaarchitect.com/2017/01/06/factor-etf-due-diligence-new-challenge-investors/#gs.KeSCItg

  35. 35.

    E. Balchunas, The Institutional ETF Toolbox, Bloomberg 2016.

  36. 36.

    D. Abner, The ETF Handbook: How to Value and Trade Exchange Traded Funds, Wiley 2010.

  37. 37.

    Investors can find this information with access to a Bloomberg terminal.

  38. 38.

    E. Balchunas, The Institutional ETF Toolbox, Bloomberg 2016.

  39. 39.

    K. Pingali, J. Liu,S. Park, and M. Baradas, 2014, Seeking Optimal ETF Execution in Electronic Markets, Journal of Trading, Vol. 9.

  40. 40.

    The average standard deviation of the excess returns.

  41. 41.

    The excess return.

  42. 42.

    The other side of the swap contract, typically a bank.

  43. 43.

    Krause, Ehsani and Lien (2014), Ben-David, Graham, and Harvey (2013).

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Authors and Affiliations

  1. Applied Quantitative Analysis LLC, Denver, CO, USA

    Elisabetta Basilico

  2. Reiman School of Finance, University of Denver, Denver, CO, USA

    Tommi Johnsen

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  1. Elisabetta Basilico
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  2. Tommi Johnsen
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Basilico, E., Johnsen, T. (2019). Index Investing: It Makes Active Management Better. In: Smart(er) Investing. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-26692-9_3

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  • DOI: https://doi.org/10.1007/978-3-030-26692-9_3

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