The low-cost passive index fund has been heralded as the retail investor’s ideal investment vehicle, providing long term reliable returns and no risk of underperforming–since, well, a fund can only underperform the index it tracks or is benchmarked against. As retail investing embraced the index fund in the 2010s, many argued that active investing was dying.
The rally cry went much further than the purpose of the low-cost index fund due to a misunderstanding of finance’s variegated functions. Thus popular websites wrote that hedge funds were dinosaurs because low-cost index funds provided superior returns, forgetting (or perhaps not knowing) that hedge funds’ primary purpose is to provide uncorrelated returns for liquidity’s sake (hence their overwhelming popularity with pension funds). Similarly, the rise of the index fund coincided with the growth of private equity, which has become a significant part of the financial world as its strong returns and new playbook have become widely accepted.
And now index funds are facing a new challenge in the form of retail active investors. In mid-2019, data from Bloomberg shows, retail trading exceeded quantitative hedge funds in terms of market share of equity trading volumes in the U.S. Retail active money rose to over 20% at the start of 2021 from 10% at the start of the 2010s. At the same time, quant hedge funds have seen a steady decline since their near-20% of marketshare peak at the start of 2018 and continued slide (quantitative analysis, using statistical models of the past, has difficulties with historically unprecedented events, which have made up the market more than anything else in the last few years).
This trend puts a significant question mark over investors’ appetites for passive index funds, and the many market theories that flow from that. No longer is the theory of the efficient market hypothesis so compelling as to lure retail investors to low-cost index funds, which may create mispricings that offer advantages to other market participants. Or, as some corners of the markets are now hinting at, the network effect of retail investors trading in tandem will be so great as to create momentum that counterparts in the marketplace cannot unwind.
Whether these theories are true or not, it appears that there is now a much bigger market for activist investing than there has been for a decade–and that may prove a valuable opportunity for all sorts of active fund managers in the coming months and years.