Since the financial crisis in 2008 the popularity of explicit indexing has increased. How is that related to the structure and performance of actively managed funds around the world?
Researcher: Miguel Ferreira
Indexing and active fund management: international evidence
This paper examines the relation between indexing and active management in the mutual fund industry worldwide. Evidence suggests that explicit indexing by index funds and EFTs improves competition in the mutual fund industry. Therefore, Martijn Cremers (University of Notre Dame, USA), Miguel Ferreira (Nova SBE), Pedro Matos (University of Virginia – Darden School of Business, USA), and Laura Starks (University of Texas, USA) are the first ones to study how indexing is related to the structure and performance of actively managed mutual funds around the world.
Explicit indexing: gaining in popularity
When documenting the extent of explicit indexing in each country through a multi-country sample with equity mutual funds and ETFs from 32 countries, considerable cross-country and time series variation is found. As it has become a common low-cost alternative for investors to access the stock market, explicit indexing has gained popularity, particularly after the 2007-2008 financial crisis. Nonetheless, closet indexing (i.e., active funds that closely follow a benchmark) is still common.
The effects of explicit indexing
The researchers find that explicit indexing improves competition in the mutual fund industry:
• Tests show that explicit indexing increases competition in the mutual fund industry and eventually benefits investors in active funds. Active funds have higher active shares and charge lower fees in markets with more explicit indexing, while closet indexing causes active funds to have higher fees.
• Evidence suggests that markets with more competition from explicitly indexed funds display active funds that pursue more differentiated product strategies to deliver alpha to investors and charge lower fees for active management.
A quasi-natural experiment using the exogenous variation in the availability of indexed funds generated by the passage of pension laws supports a causal interpretation of the results. By doing so, the concern is addressed that the availability of explicit indexing might be related to some unobserved benchmark or country characteristic that explains the active share and fees of active funds.
• Explicit indexing improves competition in the mutual fund industry, while closet indexing is indicative of the reverse
• Actively managed funds are more active and charger lower fees when they face more competitive pressure from low-cost explicitly indexed funds
• The average alpha generated by active management is higher in countries with more explicit indexing
• Active funds increase their active share and decrease their fees following the passage of a Pension Act in their country of domicile or sale
• A fund’s active share predicts its future risk-adjusted performance
Implications and further research
The primary implication of these results is that the growth of explicitly indexed funds worldwide improves competition in the asset management industry. Moreover, the continued growth of index-based investing could have broader implications for markets and asset prices, which deserves attention from future research.
About the authors
• Martijn Cremers is a Professor of Finance at the University of Notre Dame.
• Miguel A. Ferreira is Banco BPI Professor of Finance at Nova School of Business and Economics.
• Pedro Matos is an Associate Professor of Finance at the Darden School of Business, University of Virginia.
• Laura Starks is the Charles E. and Sarah M. Seay Regents Chair of Finance, Chairman at the University of Texas at Austin.
This article is based on the paper “Indexing and Active Fund Management: International Evidence”, forthcoming in the Journal of Financial Economics.