ETFs inevitably boost the value of fewer outperformers

ETFs inevitably boost the value of fewer outperformers

Across the investment world, ETFs are on the rise. And for good reason – as Tim recently noted, ETFs outperform many actively managed funds. But the growing popularity of ETFs is having another consequence – it is making outperforming managed funds even more valuable, and pushing underperforming funds out faster.

It’s very clear that passive money has gained a growing share of assets under management (AUM) over the past few years. This has been happening on a global scale and can be seen in both market share and the movement of flows. Take, for example, the continual inflows of ETFs in the US over the past 5 years, or the continual outflows of active money, as shown in the chart below.

Or look more directly at the market share of passive money in the leading US market and also the European market in the next chart.

Let’s start with getting a better understanding of passive returns.

As Tim pointed out, it is difficult for active managers to compete with passive money. Let’s have a closer look at what’s going on at the return level. We can begin by making some rules to simplify our analysis.

The market is made up of x market players. Let y (<x) of them be active and the rest passive. This makes sense:

Active managers + Passive managers = Total managers

i.e. y + (x – y) = x

So we can continue…

• But as passive returns mimic the market we can also add:
• Active returns = passive returns = total market returns

But now we consider that it is cheaper to buy the index than to be active. To compensate for this, active managers charge higher fees than passive managers. So:

The sum of active returns –  active fees < The sum of passive returns –  passive fees

What is important to note here is that we are talking only about the aggregate. Within active managers some will outperform others. These active managers achieve superior returns to the market. So we can have:

• Outperforming active manager returns – active fee > passive manager returns – passive fee
• Underperforming/ average active manager returns – active fee < passive manager returns – passive fee

What this means is that investing in every active fund will be more expensive than investing in every passive fund. However, as some active funds will perform better than others, just as some stocks will outperform, investing in these funds will lead to superior returns.

So what does this mean when it comes to investing in fund managers?

Funds earn returns and grow value from a combination of:

1. Market returns and outperformance on this – leading to more performance fees
2. Flows – leading to more management fees

As you can imagine, 1 tends to lead to 2; i.e. flows go to funds that are outperforming. So, clearly, if a fund manager is outperforming, this is good for valuation. Investors would like to own more funds that have the ability to outperform the market in the long-term. But what does the growth of passive money mean for this?

For a start, it means that there is less total flow moving in at point 2. So point 1 becomes even more important. It also means active management is becoming more competitive for the flows that do exist, so net fees have come down.

In short, the growing share of passive management increases the importance of superior market returns in valuing a fund.  Seth Klarman, the legendary founder of the Baupost Group, recently noted the growing dominance of ETFs is actually making markets less efficient, and this could end up causing investors harm, noting; “The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”  In other words investor enthusiasm for passive ETF’s will peak, at the same time that stocks are generating returns unsustainably superior to what their fundamentals suggest. Bubbles will inflate unchecked, distortions will increase and the disruptive consequences will be greater.  As Roger likes to say, ‘markets will always transfer wealth from the many to the few, from those with no patience to those with patience’.

The impact of growing ETFs makes outperforming active funds even more valuable, and underperforming funds get squeezed out of the market faster (because ETFs offer a cheaper, better performing alternative to an underperforming fund). Outperforming fund managers however will continue to provide a quality alternative and an increasingly valuable one.