The stunning growth of Vanguard heralding the move to passive or index funds over active investing especially in DC plans seems to be a runaway train. But is that good for investors?
The numbers are staggering. In the last three years. According to a NYTimes article, Vanguard has attracted more assets than all other fund families combined. In fact, they have collected $823 billion which is 8.5 times more than all other firms which is unprecedented.
With a focus on fees by investors since the last crisis, assets have risen at Vanguard from $1 trillion to $4.2 trillion with their fees falling from .70% in 1976 to just .12% in 2016 with average mutual fund fees at 1% according to Lipper.
The move to indexing in 401k and 403b plans is even more compelling as plan sponsors look to minimize the risk of lawsuits by moving to low cost index funds – P&I reports that for the first time in 2015 a majority of assets in the top 100 defined contribution (DC) plans were invested in passive investments.
So what are the dangers of index funds or passive investments? According to a Kiplinger article they include:
- Trading Costs – Indexes are constantly changing the underlying stocks that make up their formula so trades must be made to keep up which can be expensive.
- Buy High – When a new stock becomes part of an index, their price usually soars which means index funds buy high.
- Obscure Indexes – They have become so popular that some indices are hard to figure or become more like active funds like the one that follows stock that benefit from the rising spending power of Millennials like Amazon and LinkedIn.
- Switching Indices – Passive funds can switch the index they follow which, though disclosed, can be hard to follow.
- Bubbles – Indexes do poorly in a bubble as market weighted indices by their nature follow hot stocks. For example, tech stocks made up 30% of the S&P 500 in 1999 and 14% in 2002 after the 2001 tech bubble.
An economy with too much money in market weighted indexes rewards big companies for being big, which is causing concern in emerging economies, stifling innovation and good corporate governance as well as creating artificial bubbles according to academic researchers.
By focusing on certain sectors and larger firms, Fidelity research shows that investors are better able to beat the indexes. Smaller firms with less resources and higher fees might struggle to outperform their index – half of all mutual fund families control 1% of assets while the top five control almost 50%. American Funds research shows that when the fund managers actually invest in their own funds, performance is better.
With the move to target date funds (TDFs) in DC plans and Vanguard now the top choice, the issue is more complicated because there is no such thing as a passive TDF. The glide path or asset allocation by nature is active but investors might be confused because the underlying assets are passive.
So before you go all passive, make sure you understand the consequences making an informed decision.
