Do Index Funds Make Active Funds Better?

“Money managers specializing in picking stocks and bonds are being driven out by mindless passive investing.”

This is just one example of the seemly endless tension between active and passive management.

We are not writing this to try to end the debate.  It will continue without us for sure.

Our question is simply this:

Why all the complaining?

Many “too much money is flowing into index funds and dangerous bubbles are being created” like headlines and quotes continue to circulate.

The chart below tells a more complete story.

According the Investment Company Institute (an independent industry group that keeps track of assets under management in the mutual and index fund sector), the following was the percentage of U.S. stock held by index funds or ETFs at the end of 2018:

Only 13%

Next, what does research show related to how index funds and ETFs impact active managers?

Indexing makes active management better.

Yes, you read that correctly.

Peer reviewed independent research published by the Journal of Financial Economics found this:

Active funds perform better in countries that have a larger amount of assets in low cost index funds.

They also found this:

Many active managers are closet indexers.

Meaning, they claim to be active but are charging relatively high fees for simply holding index fund like portfolios.

Are some managers protesting a little too much to take the spotlight off the fact that they are actually high fee index managers or are performing poorly net of all fees and other costs?

Versus complaining, maybe managers should be wishing for a lot more than 13% of assets in the U.S. to be in index funds and ETFs.

Evidence suggests it might make them better.

Related Reading:

Indexing and Active Fund Management: International Evidence – Martijn Cremers, Miguel A. Ferreira, Pedro Matos, Laura T. Starks – 2015

Investment Company Institute Fact Book – 2019

Who Is Passive? – Provoking Posts – 2018