Funds focusing on active investing are key to the success of passive funds, the SEC's Investor Advisory Committee was told last week.
“Without the security analysis by active managers, index funds could not buy and sell securities at fairly valued prices. Index funds are free riding on active management,” MIT Sloan School of Management Senior Lecturer Robert Pozen argued.
“The roles played by active investment managers in price discovery, governance and capital formation are essential,” Robert Sharps, group chief investment officer for the active concentrated T. Rowe Price Group said.
Their comments came in an environment where passive investing shows no sign of slowing down.
Jeb Doggett, a Deloitte executive, noted in recent years passive funds have grown at two and a half times the rate of active funds to $11 trillion.
He predicted in the next five years passive funds will grow from a current 30 percent of professionally managed assets to 35 percent.
“A whole generation of financial advisors use ETFs as primary investment vehicles. They are not going to go away,” said the Deloitte authority.
But while passive strategies have been widely praised for bringing low-cost cost, low-maintenance, highly diversified, and highly tax efficient portfolios in reach of retailed investors, SEC Chair Jay Clayton acknowledged there could be pitfalls.
He pointed out some analysts contend the concentration of stock holdings by passive funds may amplify market risk.
Pozen, chair of MFS Investment Management from 200, said good corporate governance could be at risk by the passive momentum.
MFS is considered the inventor of mutual funds.
“Index funds run by smaller managers…may try to minimize the time and effort involved in diligent voting and instead robotically follow the recommendations of a proxy voting service,” said Pozen.
He added there is a labeling problem with some Exchange Traded Funds.
Pozen said investment vehicles with high expenses and conflicts of interest shouldn’t be called ETF indexes because investors may not be able to see how costly and different they are.
He added one problem with passive funds is they don’t buy IPOs.
With the lack of investment in IPOs and other small stocks, Pozen cautioned index funds automatically push up the prices of the largest stocks in the S&P500.
“The market needs active funds to help set prices of IPOs and investors will benefit from active funds that invest in the best performers,” contended the expert.
Rowe Price’s Sharps said passive managers are pushing a greater percentage of all stock trading to later in the day because they generally seek to transact at or near a security’s closing price in an effort to replicate the index return.
He added the move towards passive investing has made it more challenging for active managers to accumulate or liquidate positions in small- and mid-cap stocks because passive managers hold 20 percent or more of the float.