Stock picking is losing favor, but will never die

For decades now, finance professors, financial journalists, Jack Bogle and Vanguard have been trying to hammer it into your head: Active management is bad. Don’t pick stocks. Diversify. Buy low-cost index funds and exchange-traded funds.
Now it seems like the world is finally beginning to listen. As John Authers of the Financial Times reports, money is pouring out of actively managed mutual funds and into passive funds:
Sales of actively managed funds have collapsed, particularly in the huge market for U.S. funds investing in equities. Over the past 12 months, such funds saw redemptions exceed new sales by $92 billion, even as rival passive funds took in a net $156 billion. The money from institutions and retail investors that was already flowing instead to rival passive funds has turned into a flood. Fidelity Investments, once the world’s largest fund manager, saw $24.7 billion flow out of its active funds this year; Vanguard, its successor as the largest U.S. mutual fund group, took $188.8 billion into its passive funds.
Of course, these are flows, not totals. The vast majority of the world’s financial assets are still actively managed. Even by 2020, PricewaterhouseCoopers forecasts that only a little more than one-fifth of global assets will be passively managed. But we may have seen a turning point – signs point to a long, slow, inevitable decline of active management during the next few decades.
Why is this happening? One reason is that the so-called folklore of finance – the belief that if you’re savvy and well-connected you can find a money manager who will beat the market for you, even after fees – is being replaced by a new, more fatalistic folklore grounded in academic evidence. Academics and private-sector research firms alike have been hammering away, year after year, with studies showing how few money managers can beat the market, and how little their success persists from one year to the next.
Next, passive investing has gotten easier.
The rise of ETFs means that you can buy and sell the entire market — or a big slice of it — as quickly as you can sell a single stock. Investors tend to value liquidity, and ETFs give you the diversification of an index fund with a little more liquidity. Sometimes a little is all it takes. Third, we live in an age of low interest rates. That tends to make fees more salient, and active management has higher fees than passive management.
But as active management wanes, its definition is getting blurrier.
Once upon a time, “active” meant picking stocks, and “passive” meant buying and holding an index fund. But nowadays, your country’s stock market is only one of many assets you can invest in – there are foreign stocks, risky bonds, commodities and real estate. Of course, you can invest with ETFs. But in what proportions should you hold these various broad asset classes? Deciding how much money to put in foreign versus domestic stocks, for example, is an active decision that even passive investors have to make.
There is also the issue of market timing. Traditionally, this goes under the heading of active management, and research shows that people are poor market timers. But many of the strategies that even academics recommend, such as dollar-cost averaging and yearly rebalancing, are really about market timing.
Since a large and increasing amount of diversified investing is done via ETFs, and ETFs are highly liquid, this makes it easier to decide when to get in and out of the market as a whole. This is a fundamentally active decision.
So active management may not be dying, though investing is getting less and less active over time.
Spurred by research, new technology and macroeconomic changes, investing is getting more diversified and lower-cost. But the need to make judgment calls will never go away. •


Noah Smith is an assistant professor of finance at Stony Brook University and a Bloomberg View columnist.

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