Hard earned truth: Passive investing has changed the game

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Late last year, total assets under management in passive investment funds in the United States surpassed those in active ones for the first time, according to data from Morningstar.

The milestone was the latest evidence of a sea change in the global investment industry, one that is seeing hundreds of billions of dollars in assets per month flow into ETFs and index funds that seek to imitate the holdings and returns of a benchmark index, rather than trying to outperform the market.

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For retail investors, especially young ones with long investment horizons, the development has been a game changer.

Advantages of passive strategies

The advantages of passive funds typically include better performance over longer stretches of time, and generally lower fees, which keep more money in the investor’s pockets.

Individual investors basically had two choices before index funds came along, says Paul Calluzzo, associate professor of finance at the Smith School of Business at Queen’s University in Kingston, Ont.

“You could try to invest on your own, which is very challenging for someone who’s not very financially sophisticated. If it’s not your full-time job, it’s very unlikely that you’re going to be able to form an efficient portfolio,” he says.

“The other option, which I think made more sense at the time, even with how expensive it was, was to delegate it through active mutual funds. But the problem with that is they’re still under-diversified, because the average holdings in active mutual funds is between 30 and 100 stocks. The other issue is that the fees are insane.”

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The first index fund available to retail investors debuted in the U.S. in 1976. Since then, index funds have grown into a popular low-cost way to buy a diversified portfolio of investments, with worldwide market share for passive funds growing to 40 per cent from 21 per cent over the past 10 years, according to a report from PWL Capital, using data from Morningstar Direct.

In Canada, it’s a smaller but growing segment: Passive funds only claim 16.4 per cent market share of total assets under management, but marked eight consecutive years of growth in 2023. And, between 2014 and 2023, passive funds grew almost three times as fast as active funds, according to the PWL report.

Lower fees and higher performance

For ultra-wealthy people with the capital to access top-tier investment managers who deliver above-average returns, the high fees may be worth it. But for average retail investors, research shows that passive funds typically outperform active ones — and that underperformance rates for active funds generally increase over longer stretches of time.

The majority of active funds in Canada underperformed their benchmarks in 2023, according to the S&P Indices Versus Active (SPIVA) Canada Scorecard by S&P Dow Jones Indices, which tracks the performance of Canadian actively managed funds against benchmarks in seven respective categories. Over a 10-year period, actively managed Canadian equity funds had a 90.7 per cent underperformance rate compared to benchmark S&P/TSX Composite Index, based on risk-adjusted return.

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“Picking which stocks are going to go up is a skill that very few people have. No one has really been able to figure out a way to pick who are the active funds that are going to outperform in the next 10 years,” says Calluzzo. “And given that only like fiver per cent of them do outperform, the odds are if you try to pick, you’re going to be in the 95 per cent [that underperform], not the five per cent.”

It’s not surprising that passive investing has come such a long way so quickly. Besides diversification, index funds satisfy the pushback from investors against high management fees, says Russ Dyck, an advice-only, fee-only, Certified Financial Planner at Finovo Wealth in Calgary. With less financial gatekeeping from investment advisors, people can pursue investing strategies with lower fees.

“I feel like the bigger change for retail investors was in the mid-2010s, when we started seeing a lot more dedicated index funds for the Canadian market and the U.S. market,” he says. “It really opened the floodgates for more knowledge and more do-it-yourself investors to build their own balanced portfolios without having to watch 100 or 200 different stocks and put them all together.”

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Things to look out for

Like any type of investment product, index funds do have a few drawbacks. While index funds are transparent about their holdings, investors have no input or control over the fund’s investments.

If an index fund is concentrated on a specific sector or small number of stocks, it may not add diversification to a portfolio.

An index fund may also have slightly different holdings than the market index it tracks, and may experience more volatility.

And with so many index funds out there, investors need to understand expense ratios and trading fees to make sure costs aren’t eating into returns.

At his practice, Dyck often helps his clients draft an investment policy statement, which outlines their goals, risk tolerance and time horizon, and spells out the investing rules and guidelines they want to follow to act as their North Star when the market is going haywire.

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“If you are doing all your own investing and you know you don’t have a financial planner or financial advisor there to call on when things are going crazy or you’re second-guessing your investments, the buck stops with the investor,” says Dyck.

“But if you have the right tools in place and you know what to expect from the market with day-to-day fluctuations, then you have your investment policy statement to make sure you just stick to the plan.”

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