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For Active Funds, Winter Is Coming

Over the next decade, $1 trillion could leave actively managed funds, a lethal amount for hundreds of firms.

Jeffrey Ptak, 06/06/2017

Actively managed funds accounted for about 63% of U.S. open-end and exchange-traded-fund assets on March 31. Only three years ago, it was around 72%. Given structural shifts in the market, it’s reasonable to suppose that passive will take another 10 percentage points of market share in the next decade or so.

What does that translate to in dollar terms? Passive funds, including strategic-beta ETFs, recently held around $6 trillion of $16 trillion in U.S. fund assets. Given a semiconservative 4% annual growth rate on the U.S. fund industry for the next decade, passive assets would vault to around $11 trillion by 2027. Depending on assumptions for sources of future growth (market appreciation or flows), that would imply at least $1 trillion in outflows from active. To put that in perspective, active funds managed to rake in around $600 billion in assets over the decade ended March 31.

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Would the industry be prepared for a sharp reversal? It does not appear so. As of March 31, there were 760 fund families that offered at least one active fund. The top 10 families accounted for 53% of the market, the bottom 500 a mere 0.9%. More than 500 families managed less than $1 billion, and around 300 managed under $100 million. In other words, the active-fund business is highly fragmented. Many subscale players will have to merge or shut their doors.

There has always been a life/death cycle in the active-fund business, reflecting the industry’s attractive high-growth trajectory, potentially lucrative payoffs, easy entry, and the attending high failure rate (easier entry makes for less fear of failure and, thus, more failure). But a few factors are likely to make this phase quite different and more lethal to vulnerable firms:

> The shift toward automation
> The pressure on distributors
> The preference for low cost
> Unbundling (alpha from beta; strategic-beta/ factors from alpha)

Previously, the industry was largely unaffected by big technological and regulatory shifts. Fund companies had to adapt as business moved toward the web, but it didn’t fundamentally transform the way investment-management services were packaged and delivered to investors.

However, the move toward passives, including strategic beta and factor investing, mechanizes investing, while innovations such as target-date funds automate tasks such as rebalancing. This does change the nature of investment management itself and, in turn, how value is perceived. Most notably, it exerts strong downward pressure on fees.

It’s not just automation that’s seen to this. So, too, have dramatic changes in the way advice is rendered and priced. The opening up of platforms, increasing prevalence of fiduciary standards, and accompanying move from commission to fee-based business models have had a profound impact on advisors’ preferences.

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