The ‘Passive Revolution’ That Quite Simply Isn’t

These days, it's easy to find articles in financial media arguing passive investing is "rising," to active investing's detriment. Far harder to find: Convincing evidence this rise is happening, or that these passive investors actually exist.

Heavy readers of financial media are no doubt aware of the alleged "passive revolution" media touts as sweeping the investment world. Virtually every major financial publication has run an article-nay, a series of articles-on the subject. Most tout index products, noting what they see as the folly of active management's attempts to beat markets, and offer seemingly convincing evidence that passive is taking over.

Why "seemingly"? Simple. Almost all the articles discussing this revolution cite the huge increase in "cheap" index exchange-traded funds (ETFs) in both number and assets under management. Exhibit 1 shows you this-plotting total net fund flows into ETFs and mutual funds (of all types) individually and combined.

Exhibit 1: Shift in Product Type-Not Strategy Type

Source: Investment Company Institute, FactSet, as of 4/19/2017. Cumulative mutual fund flows and net ETF issuance, January 2014 - February 2017.

You might say, "So what? ETFs usually track indexes!" And you are correct. The problem is ETFs are rarely used passively. That's what. After all, the principal structural difference between ETFs and Mutual Funds is the former are traded on an exchange-quoted intraday, minute by minute. The latter are priced only at the close. One point of liquidity. That is why "traded" is right there in the name.

And "trade" is what people do with these. A number of prominent ETFs are among the most heavily traded securities on earth. Exhibits 2 & 3 show top ETFs by average daily trading volume versus the most heavily traded stocks in the S&P 500 in 2016 and year-to-date. (Note: We are not recommending you take any action with regard the securities mentioned-they are included solely to illustrate a point.)

Exhibit 2: ETFs Were Traded a Lot in 2016

Source: FactSet, as of 4/21/2017. Average daily trading volume, 12/31/2015 - 12/30/2016. Shaded assets are ETFs.

Exhibit 3: ETFs Are Still Traded a Lot

Source: FactSet, as of 4/21/2017. Average daily trading volume, 12/30/2016 - 4/20/2017. Shaded assets are ETFs.

It is beyond odd to look at the rise of a collection of super-heavily traded securities and dub that a "passive revolution." It is quite obviously no such thing. And, actually, ETFs are heavily used by active money managers. They are holdings in actively managed mutual funds . Individual investors use them actively all the time.

What people think of as passive ETF use is most often top-down portfolio management. That is to say, folks are trying to choose countries, sectors, categories or factors they think will do well. They just aren't taking the next step and selecting individual stocks underneath those categories, instead choosing to use a shotgun-style approach and buy the whole thing. Which is ok! But don't fool yourself-it's anything but passive.

This all speaks to a theme we've touched on here many times: Using passive products doesn't make you a passive investor. Being a passive investor means you believe beating the market is impossible, so cheaply mirroring an index-one index-is optimal. But in action, the vast majority of investors using indexes are actively deploying them. They make (potentially suboptimal) choices regarding asset allocation. They mix multiple index products so their portfolio doesn't resemble any real, actual index. They buy index products based on smart beta and factor-based indexes that amount to a list of stocks some analyst or analysts liked-active management masquerading as "indexing" for marketing purposes.

The next time you see an article claiming more and more investors owning ETFs means passive is winning the day, guffawing is the appropriate response.