The Looming Risk of Low Fees

Active, Passive Investment Management Race Heats Up

SMITH BRAIN TRUST – The race between active and passive investment management is starting to get really interesting.

For years, investors have flocked to passively managed investment funds, drawn by their low fees and the predictability of performing almost as well as a theoretical market index (since index funds have costs and indexes do not).

Last year, assets managed in passive investment funds expanded 4.5 times faster than those in actively managed funds, according to Morningstar. And by 2024, Moody's Investors Service is predicting that investors collectively will have more money stashed in passive funds than in active ones.

"One big question now is: Will that rising popularity ultimately create more risk in the market?" says Russell Wermers, professor of finance at the University of Maryland's Robert H. Smith School of Business.

As with anything in financial markets, when you have too many people in one area, it creates risk. "When things start going down," Wermers says, "you're just trying to get too many people through one little door."

Proponents of passive investing favor assets that track an entire index, an index fund or an exchange-traded fund that holds all stocks traded on the S&P 500, for example. The returns on such assets end up, with some exceptions (i.e., where the index is sampled instead of exactly replicated) being almost identical to the markets they track.

Those passively managed assets differ from actively managed investments, in which individuals or fund managers buy and sell individual stocks and bonds, hoping to outperform the indexes, but of course not always succeeding. And, as it turns out, outperforming the index isn’t easy.

Actively managed funds are having their best year since the bull market began, but still, only 54 percent of active managers are beating their benchmarks, year to date, net of costs.

Active investment managers, now, struggling to compete have begun dropping their fees.

Active fund managers typically had been charging investors management fees of 30 to 100 basis points per year, while passive investment funds can charge 15 basis points per year, or even less.

"It's good that passive funds are growing and that active fees are coming down – that benefits investors," says Wermers. "Investors benefit from lower active fees, as long as the benefits of active management stay the same."

Over the long term, research shows, fees can have a significant impact on the total return that you make

Wermers has extensively researched the relative merits of passive and active investing. And he enjoys talking about the issue. "It's a great debate – an important debate – to have," he says.

The Center for Financial Policy is hosting an all-day event on Nov. 1 to explore some important aspects of the active vs. passive rivalry, with panelists and speakers including Jim Allen, head of capital markets policy for the Americas at the CFA Institute; Sam Gallo of the University of Maryland Systems Foundation; and Samara Cohen and Gerald Garvey of Blackrock. They'll explore the issue from an investment standpoint.

In a later panel, Jonathan Sokobin of FINRA, Frank Hathaway of NASDAQ and Tim Husson of the Securities and Exchange Commission, will examine the issue from a policy standpoint, exploring whether the race is creating systemic risk issues and discussing whether policymakers have an immediate role to play.