
Why passive investing is a virtuous cycle, and we’re backing active managers
It has been another astonishing year for passive funds. In recent years, they have experienced a virtuous circle: as money has poured in, it has supported the valuations of the index heavyweights, which in turn has encouraged new investors into passive funds. Active funds have struggled to keep pace. It is tempting to see this as a self-perpetuating cycle that will continue indefinitely, but that assumption may leave your portfolio dangerously unbalanced.
The rise of passive investing
There is no doubt that passive remains in vogue. Recent data shows that ETF assets had hit £1.27 trillion by the end of November, up 36% year on year*. Flows to US equity ETFs were more than double those of the next most popular classification at £13,72bn, and the top five best-selling ETFs all tracked the S&P 500. Active funds have seen far more erratic flows – for example, they were up £1.56bn in November, but down £5.95bn in October**.
With passive funds, investors have had little incentive to look elsewhere. The S&P 500 has been tough to beat: it is up 24.7% over the past 12 months***, fuelled by another astonishing performance from mega-cap technology and consumer stocks. The dominance of large-caps – and therefore of passives – hasn’t just been a phenomenon in the US markets, with similar trends being observed in European markets in 2024.
From here, the relative strength of active versus passive funds is likely to depend on the ongoing surge – or otherwise – in the US mega-caps. This is not like the technology bubble. These companies have strong earnings and cash flow, a compelling pipeline of business, and ongoing investment in research and development.
Concentration risk: are passive investors too exposed?
Neil Robson, head of global equities at Columbia Threadneedle and manager on the CT Global Extended Alpha fund, highlights the strength of the fundamentals for some of these businesses: “Since its IPO in 2004 (we bought it here in 2005 and have held it consistently ever since), Alphabet has compounded revenues and earnings in excess of 25% per annum – for twenty years! That is almost unparalleled in terms of scale and certainly duration. Amazon has grown revenues by 25% per annum over the same twenty-year period, Meta only came to market in 2012 but they have compounded revenues at 35% per annum since then.
“Apple has grown to dominate the profitability of the mobile phone market, while buying back 42% of their outstanding stock since the end of 2012. Nvidia have been the most explosive – revenues of $27bn in the company’s fiscal year 2023 (a January year-end) are set to be close to $130bn just two years later.” He leaves out Tesla which, in his view, doesn’t share these characteristics.
In Neil’s view, these remain powerful quality franchises. There are threats to their dominance, but AI is still nascent, and these groups are likely to rule the roost. “Collectively they are spending over $200bn on capital expenditure and close to $260bn on research and development. Should this generate anywhere close to the competitive advantage and product optionality it has done historically, growth will be robust.”
However, even if you believe in the technology sector, the problem with passive funds is not necessarily whether it will win or not, the problem is the size of the bet you’re taking. If you have a holding in the S&P 500, you have 37% in just 10 stocks – Apple, Nvidia, Microsoft, Amazon, Meta, Tesla, Alphabet, Broadcom, Alphabet, Berkshire Hathaway – and 32.5% in the IT sector^. If you have an MSCI World index, you have 74% in the US and 26% in the technology sector^. This level of concentration in a single sector and in a single country goes against good investment practice.
Will active funds shine in 2025?
As well as diversifying for reasons of proper portfolio management, there are sound reasons to start looking at other parts of the market. There are signs that a more diverse group of companies may lead the market from here, which could shift the balance between active and passive. On small-caps, for example, George Cooke, manager on the WS Montanaro Global Select fund, says: “Over the last few months, we have noticed a significant uptick in interest in the asset class as investors look for more attractively valued parts of the equity market. There are reasons for optimism regarding the outlook for smaller companies.”
He says global small and mid-caps will deliver earnings per share growth around 4% ahead of large-caps next year^^. This may even out the returns between small and large-caps and, potentially, redress some of the performance gap between active and passive.
Equally, there are signs of sector leadership diversifying. Since the start of the year, technology has lagged, while industrials, energy and communication services have been stronger. It is plausible that this is a change of market mood. In the latest round of Q4 earnings reports, the sectors that have seen the strongest upgrades have been utilities and financials. While the technology sector continues to deliver strong growth, this is largely reflected in valuations. Again, this suggests that market leadership may diversify over the next 12 months.
As Zehrid Osmani, manager on the Martin Currie Global Portfolio Trust, concludes, “there are many bright spots and many sectors of the global economy that are thriving. At a high level, we believe that artificial intelligence, the energy transition and ageing population are three areas that offer some exciting long-term prospects – and our portfolio has many companies operating in those areas. But with many investors focusing on those sectors, it is essential to really understand which companies can actually monetise the opportunities – to drive an increase in their competitive position, their earnings and share prices. So having a strict valuation discipline, and a focus on fundamental research, is critical to seeing through the hype and the froth.”
It is not that passive management is necessarily bad, or active management is necessarily good. But the concentration in markets is likely to mean that passive funds are heavily weighted in a single direction. Active funds can help redress the balance.
*Source: London Stock Exchange-Listed ETF Report, 10 December 2024
**Source: Investment Association, fund statistics at November 2024
***Source: S&P 500 Index, at 24 January 2025
^Source: index factsheet, 31 December 2024
^^Source: Montanaro, fund commentary Q3 2024