Retail investors may soon have a greater say in how US stocks perform -- here's why

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  • Passive investment in the US stock market continues to grow, lifting to 44% of market share in US stock funds last year.
  • According to JPMorgan, should current trends be maintained, funds in passive US stock funds could exceed those in active funds within the next two to three years.
  • The bank says there’s a variety of factors that have contributed to the switch away from active to passive funds, although the performance of active fund managers is probably not a major one.
  • Along with the possibility of creating concentration risk and market inefficiencies for investors, JPMorgan says the increase in passive investments could see retail investors play a greater role in determining movements in US stocks.

Passive investment in the US stock market continues to grow, and will soon surpass the amount of capital sitting in active funds should recent trends prevail.

This simple-yet-effective chart from JPMorgan shows the proportion of funds under management in US stocks, breaking the results down by passive and active management.

JPMorgan

Active funds aim to beat a specific benchmark, while passive investments are designed to perform in line with a benchmark.

Based on prior trends, JPMorgan says capital invested in Exchange-Traded Funds (ETFs) could exceed that of active funds within years.

“The share of passive in US domiciled equity funds rose to 44% at the end of 2018 versus 30% five years ago,” the bank says.

“So the average pace of increase has been 2.8 percentage points per annum.

“At this pace, the share of passive in US domiciled equity funds would exceed 50% within two to three years.”

JPMorgan says there’s a variety of factors that have contributed to the switch away from active to passive funds, including a wider variety of choices for investors, competitive fees, improved levels of liquidity and greater adoption of electronic trading in stocks compared to other asset classes.

It also believes the performance of active asset managers is not a major reason behind the trend towards passive investment vehicles in recent years.

“The shift from active to passive funds appears to be structural and less related to active manager’s performance,” it says.

So what does the switch to investments designed to track a benchmark mean for financial markets, including active fund managers?

JPMorgan says it has identified four: a greater influence of sentiment among retail investors on market movements, the potential for more protracted periods of momentum in either direction along with the possibility for increased concentration risk and market inefficiencies for investors.

On concentration risk, JPMorgan acknowledges the potential for the shift to passive investment to concentrate investments in a few large products, something it says could “increase systemic risk and make markets more susceptible to flows into or out of a few large passive products”.

However, it says that despite the apparent risk, based on its analysis, there is little evidence that the increasing influence of passive funds has translated into higher concentration.

Nor does it believe the continued switch to passive investments will lead to the death knell for all active fund managers, especially for those with a proven track record.

“Initially, it could be argued that exiting of low skilled active managers could increase market efficiency, and only once passive investing begins to crowd out skilled managers as well would market efficiency decline,” JPMorgan says.

“But this decreased efficiency should represent an opportunity for skilled active managers to exploit to boost returns, creating a limit to how far passive investing can grow.”

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