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US Active and Passive Management

November 2017

In an ever-challenging and changing market environment characterized by low yield and economic and political upheaval, concerns about volatility and global recession have driven investors toward active management.

However, since 2007 a number of factors have triggered a shift toward the passive camp. These include increasing numbers of cost-conscious and risk-averse investors, technological advancements and a regulatory framework focused on transparency.

The rapid growth of passive investments is borne out in the numbers: the proportion of total US equity AUM taken up by passive investment surged from 17% (about $870 billion) in 2005 to 38% (around $4 trillion)[1] in 2016.

Indeed, the growth trajectory of passive management over the last two decades points to an equal weighting of active and passive in the near future. Driving this trend is an accelerating flow into US passive vehicles at the expenses of active funds. Passive funds have taken market share from their active counterparts, the latter of which have suffered net outflows since the 2008 financial crisis.

Cumulative outflows-inflows into Index (Passive) funds vs. Active Funds

Source: Investment Company Institute, ICI 2016 Fact Book, Figure 2.14

The increasing role played by passive investments is partially explained by a phenomenon that has come to characterise markets over the last five years — low volatility.

Volatility is usually measured, among other things, by the VIX — a volatility index showing the market’s expectation of 30-day volatility conveyed by S&P 500 stock index option prices. This indicator recently dropped to a near-record low. Furthermore, the average level of (US equity) volatility in the last five years is almost as low as the average 2004-07 pre-crisis cycle levels.

Such a scenario, coupled with the inability of active management to outperform the market, has represented fertile breeding ground for passive investments.

However, current equity volatility measures are often considered poor indicators of risk. Indeed, despite such low levels of volatility, today’s political and economic uncertainties are prime features of the investment landscape.

Given such low levels of volatility, together with perceived high levels of market risk, the question of whether active or passive management will prevail in the years ahead becomes all-important.

[1] Goldman Sachs Global Investment Research, January 9, 2017 Report, Exhibit 1

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