How passive investment and private equity created a new financial revolution

While private investors have shifted towards passive investment, institutions, such as sovereign wealth funds and pension funds, have become more active by increasing their exposure to private equity.

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The business of investing, and the ownership of the corporate sector, have seen a lot of change in the last 40 years. Private investors have shifted savings from actively managed equity funds, which seek to outperform the market, to lower-cost passive funds that track markets. Institutions and wealthier investors have gone in the opposite direction, towards greater involvement by buying stakes – and control – of companies and other assets.

The stock market dates back to 1602 with the trading of shares in the Dutch East India Company in Amsterdam. It was not until 1924, more than 300 years later, with the launch of the Massachusetts Investors Trust, that investors could access so-called pooled equity funds. These allowed investors to own a diversified portfolio of shares, transferring the burden of stock picking and day-to-day portfolio management to expert investment managers.

So-called active management grew rapidly and, by the latter part of the last century, had eclipsed direct holdings of equities for retail investors.

The role of the active fund manager is to allocate their clients’ money to those companies they think are most attractive, hopefully avoiding duds and not paying over the odds. It’s a difficult business and it is very rare for a fund to achieve sustained outperformance against the market. An analysis by S&P Global found that well over 90% of actively managed US, European and UK equity funds have underperformed their broad markets over the past ten years.

The costs of active fund management and the difficulty of beating the market led to the emergence of low-cost funds that aim to mimic the performance of the entire market by tracking an index. Vanguard launched the first index-tracking fund in 1975 and today it is the second-largest asset manager in the world. Vanguard’s approach was summed up memorably by its founder Jack Bogle as, “Don’t look for the needle in the haystack. Just buy the haystack!”. The world’s largest asset manager, Blackrock, also manages the majority of its assets on a passive basis.

Part of the appeal of passive funds is cost. A passive fund may have charges as low as around 0.2% a year while active funds can charge in excess of a percentage point more.

Yet equity markets play a crucial role in making markets efficient. By researching companies, evaluating their performance, and making informed investment decisions, active investors help ensure that stock prices reflect the latest news and information. If the entire market consisted of passive investors, there would be no price discovery, meaning that share prices would fail to react to developments affecting the underlying companies.

Passive managers have to buy stocks that are increasing in value and sell those that are declining in value to match the benchmark weighting. This can result in investors being heavily exposed to a narrow range of expensive stocks, as has been the case with the rise of the so-called ‘magnificent seven’ US tech stocks, which have come to dominate the entire US equity market.

While private investors have shifted towards passive investment, institutions, such as sovereign wealth funds and pension funds, have become more active by increasing their exposure to private equity (PE). PE firms use investors’ funds to acquire control of public or private companies, improve performance before selling the company and returning money to investors, often after 3 to 5 years. PE firms have tended to make heavy use of debt. In 2022 leverage ratios averaged 5.9 in US private equity deals, according to data from PitchBook.

The performance of PE businesses has been much debated. A study published last year by The Productivity Institute at the University of Manchester examined all PE acquisitions in the UK between 2000 and 2021 and found that acquired firms saw a lasting improvement in productivity compared to other firms with similar characteristics and, crucially, that this endured even after the PE fund sold the business. They also found that PE-owned firms tended to see stronger growth in employment and capital expenditure.

The management fees charged by PE firms tend to be well in excess of those charged by an active or passive equity fund – an annual management fee of 2% and a 20% share of profits is not unheard of. Yet a 2024 review of more than 90 academic studies of PE performance by Swedish economist Alexander Ljungqvist found that even after fees returns have historically outperformed public markets.

A harder question is whether the returns sufficiently compensate for the additional risk and loss of liquidity. PE-owned companies typically hold more debt than public companies, increasing the risk of business failure in a downturn while, unlike in public markets, funds are tied up for many years. It is also worth noting that PE’s performance has lagged behind public markets in recent years, in part due to the stellar performance of the US tech sector.

The investment landscape has been transformed, with retail investors increasingly favouring passive index funds for their simplicity and affordability, while institutional investors turn to PE for potentially higher returns, despite the associated risks and illiquidity. This divergence highlights the shifting dynamics of financial markets – and varying levels of appetite for risk and excess return among investors.