Passive Investing Continues to Gain Momentum

Despite the strength of the marketing machines of Wall Street and the financial media, the trend to passive investing marches on. Investors who are fed up with the poor results, high costs and tax inefficiency of actively managed funds are voting with their wallets. And the recent bear market had done nothing to change this trend.

While investors have added more than $250 billion in assets in passive investment strategies since the end of 2007, they withdrew more than $70 billion from actively managed funds. In the first half of 2009, almost $22 billion of new cash was added to equity index funds, while $20 billion was withdrawn from active stock funds. According to Financial Research Corp., index funds would have the majority of fund assets by 2019 if the current rate holds, up from just 18 percent a decade ago. That means a lot more of the returns the market provides would end up in your accounts instead of in the wallets of active managers.

It took Vanguard, by far the largest provider of index funds, 12 years (1976-87) to cross $1 billion with its S&P 500 Index Fund. In 1997, the fund's assets totaled $30 billion, and the fund currently has more than $83 billion under management. The Vanguard Total Stock Market Fund has more than $100 billion under management. Both had long ago surpassed the actively managed Fidelity Magellan to become the largest retail funds in the world.

The trend to move from active investing to passive investing is exceptionally strong in the institutional world. About 30 years ago, around $1 billion was invested in passive funds. By 2004, the amount invested was over $3 trillion and represented as much as 40 percent of institutional funds, such as pension plans and endowment funds.

While individual investors are waking up to the failure of active management, they do lag institutional investors in the shift to passive investing. According to the Investment Company Institute, equity index fund assets made up 13 percent of all equity mutual fund assets at the end of 2008, though it's up from 3.3 percent in 1994. The explanation for the smaller share among individual investors is that institutional investors are more aware of the academic research.

While active managers will probably never go the way of buggy whip manufacturers, their market share seems sure to continue declining as investors abandon the quest for alpha and accept market returns.