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Death of Active?

Data doesn’t necessarily support the notion that investors have gotten religion about passive investing.

Jeffrey Ptak, 10/23/2014

This article originally appeared in the October/November 2014 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.  

One of the biggest stories of recent years is the rise of passive investing. In June 2009, active funds accounted for about 79% of fund assets (active U.S. stock funds had a 31.7% market share). Fast forward five years, and that figure had shrunk to 71.5% (28.7% for U.S. stock funds), the incursion by passive funds accounting for the 7.5% erosion. That’s a big number.

On balance, the shift looks like a big positive. Studies have shown that cost is one of the few variables that can predict future relative performance, so perhaps the move to passive means investors have become more frugal in trying to boost their odds of success. Or maybe they’ve changed their priorities, focusing less on chasing the hot actively managed fund of the moment and more on using ETFs and index funds to lock-in a suitable asset allocation (which, in my opinion, is what really matters anyway). Whatever the reasons, it looks like a step in the right direction.

Laudatory as that is, however, the active/passive debate tends to get framed as a moral parable, in which investors have had their moment of revelation and clarity. By this telling, it’s all over for actively managed funds. Put a fork in ‘em. They’re goners.

Here’s the thing, though: The data doesn’t unequivocally support the notion that investors have gotten religion about costs or totally lost their faith in active investing. In fact, when we burrow into the data, we find a number of trends that raise questions about, if not contradict, those assertions. To wit:

American Funds, a large actively managed fund complex, accounted for a disproportionate chunk of the market-share erosion and outflows that active funds have suffered. American is a striking example given that its funds are cheap and many boast solid long-term records.

Actively managed large-cap funds also were the source of outsized redemptions, large-growth offerings in particular. Passive funds have made their biggest inroads to U.S. equities. Yet, active foreign-stock funds didn’t lose as much share, a curious divergence.

Investors do not appear to have been uniformly repulsed by pricier active funds; alternative funds, for example, gained market share. On the flipside, some low-cost active funds, like municipal-bond funds, lost meaningful market share, despite there not being a ready passive substitute.

Last but not least, active funds gathered nearly $1 trillion in net inflows over the five-year period ended June, with taxable-bond funds leading the way.

In the following sections we explore each of these issues in further detail.

Ugly American
Time was, advisors viewed American Funds as the “safe” choice among a sea of mostly mediocre, or worse, options in the load-fund universe. American largely reciprocated this loyalty with good performance at a modest price. It also reinvested heavily in field-support and education efforts that reinforced its philosophy and value proposition among the advisors who used the funds.

But then change came. The funds faltered during the financial crisis, yes, but the real catalyst was the evolving advisor business model. Advisors were breaking away from wirehouses and levying a percentage fee on assets, in exchange for which they offered more-holistic planning and wealth-management services. To deliver, they had to show they were upholding their fiduciary duty, which meant building solutions from a wider array of options in a more transparent way. More prosaically, some advisors needed to find a way to rationalize the all-in cost of their service, which might have risen otherwise if they continued to use actively managed mutual funds alone. Enter passive funds.

Let’s be clear: There’s no question that some advisors had simply had it with active funds, threw in the towel, and that explains some of the redemptions from American Funds. But it also seems oversimplistic to conclude that the outflows—which, again, account for a sizable chunk of the market-share loss active funds have suffered—stand as some kind of outright repudiation of active investing. After all, we’re talking about a family of low-cost, largely successful funds, hardly the poster children for active management’s futility.

The broader narrative—in which financialadvisor business models changed significantly, prompting a re-evaluation of how they built portfolios and the cost of doing so—should tinge the way we look at the shift that’s taken place. The corollary to that is we shouldn’t necessarily jump to the conclusion that advisors’ bedrock investing principles have irreversibly changed—that they’ve been reborn as indexing zealots and won’t ever go back.

Large-Cap Exodus
Passive funds have made the biggest inroads within U.S. large-cap equity, where they’ve taken lots of share. Over the five-year period ended July, passive funds’ share of U.S. large-cap assets rose from 8.5% to nearly 12%.

(The market-share losses would have been far worse it not for the fact that U.S. equities have handily outgained most other asset classes in recent years. All told, investors pulled a net $143 billion from actively managed U.S. large-cap funds, ex-American Funds, over the five-years ended July, while adding a net $295 billion to passive large-cap funds.)

This makes logical sense. It’s tough for active managers to make a living in large-caps given how widely those names are followed and the disappointing results largely show it: More than 80% of large-blend funds had lagged Vanguard Total Stock Market Index Fund VTSMX over the trailing decade ended July 31. What’s more, domestic large caps typically comprise a large share of the typical U.S. investor’s equity allocation. Thus, they’re good candidates for indexing, as the cost savings can meaningfully lower the portfolio’s overall internal expense ratio.

But that’s hard to reconcile with what we’ve observed in other, ostensibly similar, areas that haven’t seen the same torrential outflows of assets to passive funds. Take actively managed foreign large-cap funds, for example, which have lost some share to index funds, but not to the same extent. In fact, such funds gathered $97 billion in net new monies over the five-year period ended July. This despite the fact that active foreign funds haven’t fared especially well, either (nearly 70% trailed Vanguard Total International Stock Fund VGTSX over the trailing 10 years ended July 31), and there’s probably even greater cost savings to be had since foreign active funds tend to cost even more than their U.S. counterparts.

Why haven’t investors shown the same reluctance to invest in foreign active funds as U.S. active funds? One simple reason is that American Funds didn’t have much of a footprint in the foreign large-cap categories in question. That aside, it’s also likely that some investors continue to view foreign stocks as an area that’s more hospitable to active investing and, therefore, worth paying up for (despite evidence seemingly to the contrary). But looking beyond that, it’s also quite possible that foreign active funds don’t carry the same stigma as active U.S. large-cap funds, which were badly oversold to investors during the tech run-up, only to leave them feeling burned when the bubble burst and the financial crisis followed.

That’s a roundabout way of saying that, for all of the talk about investors “getting ” the importance of cost and the perishability of active management, past performance still seems to inform decisions. And that, too, should color the way we think about the active/passive shift that’s underway—investors are being selective about their decisions to index and, in at least some cases, this likely reflects the same kind of reactionary behavior and psychology that put them in active funds to begin with.

Still Paying Up
Speaking of which, investors have shown no compunction about paying through the nose for alternative mutual funds, nearly all of which are actively managed. Alternative funds had gathered $152 billion in net inflows over the five-year period ended July. As of July, the typical alternative fund charged 1.72% in annual expenses, or more than 10 times the cost of Vanguard Total Stock Market Index Fund.

On the flipside, assets have only trickled into muni-bond funds, which shed about 2.3% of market share (from 6.2% of industry assets to 3.9%) over the five-year period mentioned. True, those funds are actively managed, but that’s because indexing isn’t really viable in the less-liquid municipal market. Moreover, muni funds generally don’t cost much, at least when compared to pricier stock or alternative mutual funds. So, at a time investors were supposedly getting more serious about cutting costs and embracing indexing, they committed the apostasies of buying pricey active funds and ditching cheap ones with no passive substitute. What gives?

With respect to alternatives, this at least partly reflects the new paradigm of pairing ultra-low-cost “beta sources” like broad-market index funds with supposed “alpha-generators” like alternative funds. Shabby returns of alternative funds aside, it’s worth noting that this is less a rejection of active investing as a reordering of the component pieces: Out go the more-correlated active stock and bond funds, in go the less-correlated alternative funds. Seen that way, passive funds are just a different means to the same end—trying to beat the market. (The same goes for the burgeoning crop of managed ETF portfolios, in which strategists actively invest across various passive ETFs; that’s a topic for another day.)

Munis are a different story altogether, as some of these assets probably flowed to tax-sheltered guaranteed products like variable annuities as well as hedge funds and dividend-paying stocks (including REITs, MLPs, and BDCs). But it wasn’t an active/passive story, per se, and it’s at least plausible that a chunk of those flows went from muni funds into actively-managed vehicles of some other type.

Still Chasing
Taxable-bond index funds like Vanguard Total Bond Market Index VBMFX raked in about $315 billion in net inflows over the five-year period ended July. That’s a good haul but pales in comparison to actively managed taxable bond funds, which took in a staggering $743 billion in net new monies.

Why were investors seemingly more tolerant of active management in the taxable-bond world? To be sure, there were some very deserving managers, such as DoubleLine Capital’s Jeffrey Gundlach, who’d trounced the index. But the same could be said of some U.S. equity managers, and that didn’t stop investors from yanking far more money out of U.S. active stock funds than they put in. What it probably comes down to is absolute returns and investor psychology—that is, these outperforming active-bond managers made money for their investors but didn’t utterly traumatize them in the process.

If there’s enduring wisdom in keeping costs as low as possible (and, correspondingly, in taking a dim view of active managers’ ability to make hay after costs), why didn’t it hold in taxable-bond land? In general, investors punished active managers in asset classes that lost them gobs of money. The money flew out and went into index funds. But that didn’t play out to the same extent in taxable bond funds, which showed better returns and, thus, were an easier sale. Thus, actively managed taxable-bond funds got a pass.

False Sense of Victory
As practitioners, we can take some satisfaction in knowing that investors have increasingly chosen passive over active. Not because of its inherent, unquestionable superiority, but because for so many of those investors—who lack the time, energy, or inclination to do the research needed to successfully pick active funds— it’s the practical choice that enhances their odds of realizing a good outcome. We’re in the outcome-improving business, after all, so if passive is going to get the job done better, we should feel good about effecting that change, to the extent we did.

That said, we shouldn’t lull ourselves into a false sense of victory in which the work of persuading investors to do the practical thing is over or, conversely, that the opportunities available in doing the “harder” thing of picking active funds are gone. Judging from the data, some investors have gone passive for complex reasons, which raises questions about how committed they really are to low-cost, widely diversified, not-instant-gratification investing. Meanwhile, other investors have continued to pump money into pricier funds, or pull it from cheaper ones, at a time they’re supposedly getting serious about costs.

Taken together, it’s a picture of investors trying to sort through a jumble of different emotions and circumstances, sometimes without the resolve or consistency that the “active is dead, passive forever” narrative would lead one to believe. There’s still plenty of work to be done, and the flight to passive shouldn’t lead us to conclude otherwise.

 

The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without notice, do not constitute investment advice and are provided solely for informational purposes.

Please note that references to specific securities or other investment options within this piece should not be considered an offer (as defined by the Securities and Exchange Act) to purchase or sell that specific investment. Past performance does not guarantee future results. Morningstar Investment Services shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. 

©2014 Morningstar Investment Services, Inc. All rights reserved. Morningstar Investment Services, Inc. is a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. The Morningstar name and logo are registered marks of Morningstar, Inc.

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