The Rise and Rise of Passive Investing

According to Morningstar Research, US index funds took in US$492 billion in 2016, whereas actively-managed funds saw outflows of US$204 billion. In particular, equity-based index funds saw inflows of US$390 billion while equity-based active funds saw outflows of $423 billion.

Index funds are known as passive investment vehicles because they track simple stock market indexes. Active funds, on the other hand, are given the label “active” because there are managers picking the stocks that go into the funds.

Why is there this huge difference between the fund flows for passive funds and active funds? One key reason is cost. Active funds typically have expense ratios between 0.5% and 1%. Some may even go up to 2% or more. Some active funds also come with sales charges (or front-end load fee) and back-end load fees that can amount to over 3%. So even before making a return on his or her investment, an investor in active funds has to pay various charges.

Vanguard, a behemoth in the US passive funds market, has an average expense ratio of just 0.12%. There are also no front-end and back-end fees for Vanguard’s funds.

Cost is important, because it eats into performance. It’s likely that more and more investors have realised that the costs associated with active funds are not in their interests. Statistics from the US Department of Labour show that a 1% difference in fees and expenses translates into a 28% reduction in an investor’s total portfolio value over a 35-year investment period. No wonder Einstein reportedly called compound interest the eighth wonder of the world. “He who understands it, earns it. He who doesn’t, pays it.”

A study of 3,870 active funds over a 32-year period from 1984 to 2015 was published by Philipp Meyer-Brauns of Dimensional Fund Advisers. His paper, Mutual Fund Performance Through a Five-Factor Lens, concluded that the “vast majority of active managers are unable to produce excess returns that cover their costs.”

Essentially, passive investing follows a strategy of low-cost diversification. And the movement of capital out of active funds into passive funds makes a lot sense from a cost perspective.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.