Passive Management: ETF “dark matter”
May 1st, 2007 | Filed under: CAPM / Alpha Theory
Last week’s Economist piece on the ballooning ETF industry contained a chart that gave us pause (right). It illustrates not only the growth of ETFs (vs. traditional open-ended index funds), but also the overall growth of indexing (currently over 16% of all US equity mutual funds). While 16% may sound high, that’ nothing compared to the hidden ETFs buried within all US equity mutual funds. It’s as if there is a huge amount of “dark matter” hidden between active stock picks.
We were reminded of this study by Martijn Cremers & Antti Petajisto of the Yale School of Management (originally written last summer and covered in these pages but recently updated). Cremers and Petajisto propose a new measure of active management to complement the traditional market correlation measure (a.k.a. “tracking error”). Instead of looking at a fund’s return stream to infer the size of its active and passive components, the new metric actually measures the deviation of each holding from index weights. Cremers & Petajisto suggest this measure be used as a complement to, not a replacement for, tracking error.
Like The Economist, the researchers were also curious about the recent history of mutual funds. Their paper contains the following chart.
Cremers & Petajisto show that the average “active share” of an S&P 500-benchmarked mutual fund has drifted from nearly 90% in 1980 to less than 70% today – a drop of about one-fifth. Note how the precipitous drop in active management beginning in the early 1990’s coincides with the beginning of the golden era for ETFs in The Economist’s chart. It seems that the rush to passive management had a less-visible, but equally-large corollary in the form of index-hugging in (non-index) mutual funds.
These twin forces have actualy increased the proportion of passive management from around 20% in 1990 (index funds and passive management combined) to around 40% (index funds and passive management combined) by 2003. Put another way, index funds and ETFs account for only about a quarter of all passive management.
In addition, the dramatic growth of ETFs and index funds since 1990 (+10% of all mutual funds) is trumped by the growth of passive management (+15% of all mutual fund assets).
- Alpha Male
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[...] And this chart (right) from a recent Economist article (see posting) combines Vanguard’s estimates and ETFs onto one chart. [...]