As regular readers will know, we believe that unbundling active and passive management leads to greater fee transparency, more flexibility and ultimately more tailored portfolios. While this trend may not be immediately apparent in the day to day decisions made by advisers and investors, it reveals itself in the twin growth trajectories of ETFs and hedge funds (see related posting). ETFs, after all, are the cheapest way for an individual investor to buy pure beta and hedge funds – believe it or not – are often a cheaper way to buy active management than purchasing it embedded in mutual funds.
So when we see headlines suggesting that the wealthiest American investors are shying away from ETFs, we wonder what’s going on. Yesterday, a few media outlets picked up on an interesting study by Advisor Perspectives that showed index funds comprised less than 4% of the portfolios of the wealthiest American (and, supposedly, the most sophisticated investors). This does sound low. And so it’s no surprise the headlines rang out: Wealthy hold few assets in indexed funds, and Study: High-Net Worth Investors Not Keen on Index Funds. Conclusion: smart investors shun indexing.
But after a detailed reading of the study and a phone call to its author, Advisor Perspectives CEO Robert Huebscher, it appears the universe is still unfolding as we have hypothesized.
While the highest net worth investors held only 3.8% of their marketable securities in the form of indexed products, that segment only held 14.3% of its marketable securities in the form of any type of mutual fund (including ETFs). In other words, they held a much higher 26% of their mutual allocation in the form of indexed products (of either the ETF or mutual persuasion) and 74% in traditional mutual funds.
So what did they do with the other 85.7% of the “marketable securities” allocation? Advisor Perspectives’ Huebscher says it’s mostly invested in individual securities. This makes intuitive sense when you consider that the mutual fund was invented for those who can’t afford a separately managed account (SMA). With SMAs, the wealthy essentially have the rest of their liquid assets in private, customized mutual funds managed by their broker. Which begs the question – how much of that private mutual fund is essentially beta and how much is alpha? (At the end of the day, it may turn out that the uber-rich actually have a lot more indexed than this study actually suggests – but we’ll avoid that issue here.)
Contrast this 26% indexed figure with the comparable number for the average smaller account (average value: $119k). This segment holds 3.3% of their marketable securities in the form of indexed products (also low-sounding, but similar to the 3.8% above). But overall, mutual funds and ETFs represent a whopping 45% of their marketable securities portfolios. So the index portion is a paltry 7% of their overall mutual fund allocation. This leaves 93% in traditional mutual funds.
As a reference point, a study by the Investment Company Institute shows indexing now represents about 12% of the equity mutual fund industry (see chart below).
And this chart (right) from a recent Economist article (see posting) combines Vanguard’s estimates and ETFs onto one chart.
So it appears the rich do get it after all. As one might expect, they allocate way more of their mutual fund dollars to ETFs and index funds than any other group – a far cry from concluding the wealthy are “not keen on index funds”.
But what about the pure active part of alpha/beta portfolios? Says Huebscher, the study didn’t even look at hedge funds, real estate and private equity. If he had, it would almost certainly have been a significant number. After all, the wealthy are the only ones qualified to buy many of these products.
So where does all of this leave sophisticated US investors? Hedge fund (alpha) and index fund/ETF (beta) allocations are higher than average while allocations to actively managed mutual funds are lower than average. Sounds pretty good to us.