Vanguard CIO Greg Davis says passive investing will keep getting bigger, as he rebutted criticisms by active stock pickers that the huge rise in indexing was fuelling financial risks.
Vanguard chief investment officer Greg Davis says passive investing will keep getting bigger, as he rebutted criticisms by active stock pickers that the huge rise in indexing was fuelling financial risks.
Mr Davis said market-tracking index funds accounted for only a “tiny fraction” of the daily trading volume in equities and bonds, arguing that it was active managers who still overwhelmingly set the prices of securities.
“We think that the price discovery mechanism in the marketplace is still determined primarily by these active managers,” Mr Davis said in an interview from the US with The Australian Financial Review.
“Index funds are primarily price takers, not price setters.”
Vanguard figures suggest that index funds represent about 5 per cent of the daily trading volume in US equities.
Financial market followers have focused heavily on the estimated 35 per cent of total mutual fund and exchange traded fund (ETF) assets in the US being invested in index-tracking products.
But the overall proportion of money allocated to indexing is said to be lower.
For both US and global equities, Vanguard estimates about 15 per cent are held by index funds and ETFs, including other investment vehicles such as hedge funds, pooled accounts managed by brokers, pensions, endowments and holdings by individuals.
Less than 20pc of the market
BlackRock, a large ETF provider, estimates that indexed assets account for less than 20 per cent of the $US68 trillion global equity market.
Index funds mimic the performance of market indices for shares, bonds and other asset classes. They give investors economic exposure to the underlying basket of securities, generally at lower prices.
Some professional stock pickers have claimed the surge in money allocated to index-tracking products such as ETFs may be fuelling asset price bubbles and could be exposed to liquidity risks in the event of a sudden market exodus by investors.
Investors in the US poured a record $US505 billion into passive fund strategies for equities, bonds and commodities in 2016, according to Morningstar. Investors withdrew $US340 billion from active funds such as Fidelity, Franklin Templeton and T. Rowe Price. The trend has persisted this year, monthly reports show.
The sharp rise in money allocated to index products has put active mangers under enormous competitive pressure – both on fees and employment.
Investors want ‘lower-cost options’
Vanguard’s Mr Davis said the decisive shift from active to passive funds management would persist due to the lower costs.
“In an environment where bond yields are somewhat depressed, forward looking equity returns are expected to be somewhat lower given the starting valuations, investors are gravitating towards lower cost options,” he said.
Financial advisers and some individual investors had shied away from picking individual stocks since the 1980s and 1990s and there was greater focus on diversified asset allocation, he said.
Vanguard’s assets under management have surged to nearly $US5 trillion, including about $US1.2 trillion of funds that are actively managed by professional stock and bond investors.
Investment companies offering index funds and publicly traded ETFs have branched out beyond traditional market benchmarks such as the US S&P 500 and the local S&P/ASX 200.
They now include the NYSE FANG+ index of 10 internet and media companies such as Facebook and Tesla, a whiskey distillery ETF and ETFs based on US companies that may benefit from Republican or Democratic Party policies.
Asked if some ETFs were becoming too exotic or risky, Mr Davis said factor investing or so-called Smart Beta incorporated a portion of active management.
“To the extent you have any deviation away from the market that’s some form of active,” he said.
“Narrowly defined sections of the market, it is buyer beware and people need to understand the risks.”
‘Love of property and cash’
Mr Davis worked in Melbourne in 2013 and 2014 as Vanguard’s Asia Pacific chief investment officer and still travels to Australia about once a year.
“The one thing that’s always struck me about Australia is just the love of property and cash,” he said.
Vanguard founder and pioneer of index-based investing, Jack Bogle, said last month that indexing could eventually hit a limit of “70 or 80 or 90 per cent” of the market.
Mr Davis wouldn’t be drawn on the limit of indexing, but said, “I absolutely think it can get bigger” than current levels.
“I don’t know what that number is. But what people need to look at is how price is being determined in the marketplace,” he said.
Activist hedge fund manager, Elliott Management’s Paul Singer, has accused passive managers of “devouring capitalism” and being an enemy of free markets.
Mr Davis said many index funds were long term investors.
“We are perpetual owners of these companies.”
“We have a very strong interest to make sure these companies are governed in the right way.”
Large index providers such as Vanguard, BlackRock and State Street have faced questions from critics about whether there are devoting enough resources to corporate governance at companies they are invested in, such as shareholder votes on executive remuneration and director appointments.
Vanguard has a bit over 20 people in its “investment stewardship team” that has voted at nearly 19,000 shareholder meetings and held more than 950 engagements with company leaders and directors in the past year.
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