THE BLOG
01/16/2015 10:33 am ET Updated Mar 18, 2015

Memo to Investors: Join the Parade

In the last year and a half, approximately half a trillion dollars has flowed into passive index strategies. This is around four times the flow into active strategies during the same period. Should you join the parade, abandoning actively managed funds and investing instead through Indexed mutual funds and ETFs? Indeed you should, and here's why.

In general, active managers seek to outperform the stock market or various segments of the stock market, for example small cap stocks or technology stocks. They charge hefty fees for their efforts, and incur substantial expenses for marketing and distribution, which, one way or another, are passed on to investors. And they almost always fail to deliver. Last year, as few as 10 percent of US active managers outperformed the stock market or the relevant benchmarks. 2014 was particularly dismal for active management, but the long term picture tells a similar story. Over the past 15 years, some 75 percent of growth funds underperformed, as did 85 percent of emerging market and international managers.

Moreover, if you have picked a fund which has outperformed, you cannot count on the outperformance to continue. The statistics show that past performance simply does not persist. Standard & Poor's reports that of the 687 funds in the top quartile as of March 2012, only 3.8 percent managed to stay there by the end of March 2014. If manager performance were purely random, one would expect outperformance to persist more often than that. The SEC requires mutual funds to state "past performance is not a guarantee of future results." The SEC is right: not only does past performance not guarantee future results, but it appears not to predict future results at all.

Of course, we can always make better investment decisions with 20/20 hindsight. So far, we have been gazing in the rear view mirror. That is a dangerous way to drive, and a dangerous way to invest. But on this subject, the future for active management may be even worse than its uninspiring past. The reason is not well understood, but is grounded in the subtleties of index investing. The major stock indices weight stocks according to their market capitalization; the higher the price of a stock, the bigger its share of the index. This introduces a pro momentum bias in the stock market. Stocks that are going up get a bigger share of new money flowing into index strategies.

Active managers often claim to be seeking an advantage by holding stocks that are cheaper than similar companies or their historic valuations. And they tend to invest in stocks with smaller than average market capitalization. After 2014's experience, more and more professional investors are giving up on active management and switching to indexation strategies. Retail investors are making the same judgments. A trend toward indexation has been in place for decades. But In the last 12 to 18 months, we may have reached a tipping point. And in a real sense, investors switching from active to index strategies may prove to be making self-fulfilling prophecies. Active managers will be forced sellers of the stocks in their portfolios, and index strategies will profit from the momentum effects of money flowing their way.

Generally, contrarian investors take home the big prizes. Not this time. Join the parade.