The recent history of the investment industry is a tale of the two ‘P’s of finance: passive and private investing. Their explosive growth has turned the equity market on its head. 
Cheap and easy to use, index-trackers have proved popular with investors of all stripes, threatening to transform stock-picking into a niche pursuit.
Private equity, meanwhile, has found favour with a smaller but growing cohort of wealthy and institutional investors, who are attracted to its potentially higher returns and diversification benefits.
The growth of the ‘two Ps’ has been such that, together, they now account for $12trn of investible assets – a fourfold increase on a decade ago and $1trn more than the total held in actively-managed equity funds.
So far in this story passive investing has been the chief protagonist. Index-tracker assets have grown 14 per cent per year in the past 10 years, eclipsing private equity’s 8 per cent.
But the next chapter will contain a plot twist. Passive investing will have demons to confront, private equity new avenues to explore.
Whatever the vantage point, it appears the passive industry’s best days are gone. Regulators are increasingly concerned at the side-effects of its expansion. One problem is that, as index funds develop into a dominant investment force, they threaten market stability – as the Federal Reserve itself has warned.
Another worry is that passive investing concentrates share ownership and stifles competition. Academics have linked the growth of index-tracker funds to a phenomenon known as common ownership, which occurs whenever companies operating within an industry are controlled by the same investors. In such conditions, firms have fewer incentives to innovate and compete with one another. That common ownership is cropping up more often as index-tracker funds gather assets is unsurprising. After all, the passive investment industry is an oligopoly controlled by just a handful of the world’s very biggest investment firms.
Already, the three largest passive fund managers collectively own more than 20 per cent of US large-cap stocks; their outsized footprint can also be seen across the world’s major industries. The economic ramifications are serious.
In the pharmaceutical sector, where common ownership is high, researchers found firms were less likely to produce non-branded versions of successful branded drugs, restricting consumer choice. Similar trends are unfolding in other industries in which passive shareholders hold sway, such as airlines and banking.
Governance is also attracting regulatory scrutiny. Passive investors, by definition, cannot vote with their feet, making it harder for them to hold firms to account for poor performance on environmental, social and governance (ESG) grounds. The OECD and Japan’s Government Pension Investment Fund are among those that have drawn attention to such issues.
Private equity, of course, comes with problems of its own. Historically it has been considered too risky for all but the most experienced, professional investors.
But attitudes are changing. One reason is the sheer size of the market. In the US, private companies are proliferating as businesses can afford to stay private for longer. The median age of a firm going public has risen to 11 years in the last decade from seven years in the 1980s. Meanwhile, since 2000, the number of listed companies in the US has fallen to 4,000 from 7,000.
These trends are strongest in the tech sector. Here, businesses do not require more funding that private markets can provide. This is chiefly because they rely on intangible assets rather than plant and machinery to maintain growth. What is more, private equity offers the possibility of benefiting from operational improvements in the way businesses are run. According to the US Committee on Capital Markets Regulation, private equity buyouts generally have a positive effect on both productivity and job growth in target firms.
The implications for investors are clear. Greater rewards are on offer to those who invest during the private phase of a company’s life.
Private investments can fulfil responsible investment goals too. Although private equity has been a laggard in incorporating ESG considerations, this is changing. Private markets are home to a growing range of environmental investments. Venture capital funding for clean technology, for example, topped $16bn in 2019 – a 3,750 per cent increase versus 2013, according to PWC.
The upshot is that arguments for opening up private equity to individual investors are too loud to ignore. The US is listening, with regulators there laying the foundations for ordinary savers to invest in PE funds through employer-sponsored 401(k) retirement accounts. The UK and continental Europe are following a similar path.
The expansion of private equity won’t be problem-free. Fees remain high, investment structures can be complex and returns differ greatly from fund to fund. Due diligence is more important in private equity than in public markets.
According to our research, the difference in performance between the fifth and 95th best-performing US private equity fund in US small caps is 52 per cent.
For all this, it appears private equity is poised to capture an ever-growing share of the equity investments. Passive equity, in contrast, could be approaching a plateau.
Supriya Menon is senior multi-asset strategist at Pictet Asset Management. The views expressed above are her own and should not be taken as investment advice.