From the October 2008 issue of Wealth Manager Web • Subscribe!

October 1, 2008

THE RICH ARE DIFFERENT

Wealthy investors have not embraced index funds. Advisors who manage funds for high-and ultra-high-net-worth investors have a mere 6.9 percent of their marketable securities in index funds and ETFs. F. Scott Fitzgerald supposedly said, "The rich are different from you and me--they have more money." He could have added that they don't invest passively, either.

Compared to wealthy investors, all other types of investors allocate a higher percentage of assets to index funds. Dartmouth Prof. Ken French, in his recent study, "The Cost of Active Investing," noted that as of 2006, 12.6 percent of U.S. open-end mutual fund assets were invested passively, and institutional allocations to passive strategies were considerably higher--ranging from 31.2 percent in defined benefit plans to 52.7 percent in public funds.

The percentage allocation to passive investing has increased over time, particularly among mutual fund assets. Passive assets in mutual funds were only 5.8 percent in 1996, more than doubling through 2006. Institutional assets rose slightly over the same period: Defined benefit plans were 30.7 percent passive and public funds were 48.5 percent passive in 1996.

Data for HNW investors comes from the Advisor Perspectives (AP) universe of approximately $50 billion of assets managed by advisors, with an average account size of about $900,000. Since HNW investors typically hold six or more accounts, the typical investor in the universe has more than $5 million in assets. Data is collected electronically from a broad range of custodians.

There has been a modest increase in HNW passive assets. In June 2007, 3.9 percent of marketable securities were in passive products, rising to 4.6 percent in September 2007, and to 6.4 percent in March 2008. Only 27 percent of passive investments are tied to the S&P 500, with another 14 percent tied to the MSCI EAFE. Most passive investments are tied to style box indices or to regional international indices. The top 10 index funds and ETFs--ranked by assets held in the AP universe--are shown in the chart (below left).

There is no clear explanation for the aversion to index funds among wealthy investors. One reason may be that advisors utilize tax-efficient passive products through separately managed accounts. Another is that wealthy investors have access to a broader range of products--including hedge funds--that offer better risk and return characteristics than index funds. It may be that advisors are able to identify actively managed funds that consistently outperform passive alternatives. Lastly, HNW and especially UHNW investors are not saving for retirement. Their retirement plans are well-funded, and their investment portfolios could be structured to take on a higher degree of risk than what is offered through passive products.

French's study shows the average investor sacrifices 67 basis points in annual return by choosing active funds over passive investing, and that this percentage has been relatively constant over time. That translates to a cost of approximately $100 billion. The rich may in fact be different, but their aversion to passive investing comes at a high price--at least on the theoretical level documented by French and other researchers.

Robert Huebscher, rhuebscher@advisorperspectives.com, is CEO of Advisor Perspectives (www.advisorperspectives.com), a free online database and weekly newsletter for wealth managers and financial advisors.

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