The passive versus active debate is a ‘thought experiment’ according to Joy Yang, Head of Index Product Management at MarketVector Indexes, one that provides a natural balancing force when participants find alpha opportunities.
Yang has 25 years’ worth of experience in investing and expects that as passive grows and impacts market efficiency, more active participants will enter the market and become more transparent about their fees and value added.
According to recent ISS Market Intelligence research, index funds will control more than half of long-term invested US assets by the end of 2027, which might signal an investor preference for passive index funds due to their simpler, lower-cost approach over active strategies. But it poses the question of whether we are at risk of the influx of interest in passive funds making markets inefficient.
MarketVector Indexes has a track record of developing investable indices servicing global clients. “My background has been in both passive and active so I like to think I can speak to both of those dynamics,” says Yang, who now works for both passive and active asset managers.
“For passive managers, we design the index and they replicate investable indices,” she explains. “Whereas for active managers, we are designing the index for them to benchmark their performance. Our aim is to always think about investable indices, because you can design the perfect index to model an asset class, but to be used as an investment solution, you want to think about cost and liquidity trade-offs that are needed.”
Yang comments that there is an on-going active and passive debate because of the rise in both passive investing and ETFs, to the extent that some headlines have been concerned about how much further passive should go before the markets break down or become inefficient.
“Passive managers don’t generally focus on the fundamental price, whereas active managers tend to think about the fair value of a company and the price at which it is buying and selling,” she says. “Now we are seeing more active managers coming into this structure. I think the inflow or rise of active managers choosing the ETF structure is a good thing, as it is a more efficient structure. They are bringing their strategy to a wider market, but along with that comes the requirement of suitability where the end investor understands the product they are buying.”
Yang believes that ETFs are a good structure, as they are regulated to have more transparency and are an overwhelmingly more cost-effective fund wrapper for strategies, whether passive or active. “But where active managers may fall short is that it doesn’t matter what you wrap your fund in – if it is not performing, it is not performing. Empirically, active managers don’t outperform the market.”
Yang observes that there are two ways active managers use ETFs. The first is wrapping their strategy in an ETF structure, which requires them to be more transparent. This is good, she says, highlighting the liquidity of the underlying assets. The second way is actively asset-allocating to ETFs, which is less price distorting, she says.
“They can get exposure across a broad basket of stocks in ETF structures that can be traded in the secondary market without directly trading the underlying stocks.”
The rise of the ETF fund-of-fund approach is growing, she notes, also emphasising the importance of watching the fee structure.
The largest asset managers in Europe and the UK have proved slow to use the ETF wrapper, she says. Whereas in the US, active managers have been reluctant to dip their toes into ETFs because they don’t want to give away their secret sauce.
Yang dismisses the semi-transparent ETF model in the US, saying: “Models that give protection to active management IP lose some of their efficiency, as wider bid/ask spreads develop if the market can’t efficiently price the underlying due to a lack of full transparency.”
