A Surprise for Passive Funds

Note: This is an excerpt from the Morningstar Direct U.S. Asset Flows Commentary for January 2019. The full report can be downloaded here.

Long-term flows bounced back with $39 billion in January inflows after $83 billion of outflows in December, yet they trailed by wide margins the previous two January hauls, which were $132 billion in 2018 and $63 billion in 2017. The 12-month trend in long-term flows remained weak with only about $56 billion in inflows during that stretch.

January's biggest surprise may have been the relative flows for active and passive U.S. equity funds. Passive funds fared worse than their active counterparts for the first time since January 2014. U.S. equity funds had modest outflows of $3.8 billion overall, despite the S&P 500 gaining 8% (the index's best January since 1987). On balance, these outflows came from passive U.S. equity funds, while active flows were flat.

It's possible that rebalancing by target-date funds and managed portfolios once again drove these passive U.S. equity flows. Because of January's strong equity returns, managed portfolios, such as target-date funds, with fixed allocations to individual funds may have been forced to trim their U.S. equity funds because of January's strong returns. Consider that iShares' passive U.S. equity funds had $13 billion in outflows, a firm record. Vanguard fared better, but  Vanguard Total Stock Market Index (VTSMX) collected just $1.1 billion in January after taking in $14.1 billion in December, a month in which the S&P 500 fell more than 9%.

Sector equity funds fared even worse in January, losing $8.3 billion to outflows. This follows $17.9 billion in December outflows and $43.3 billion over the past four months (including January), easily the worst four-month stretch in the past 10 years. As with U.S. equity funds, passive vehicles fared far worse than actively managed offerings. Passive sector equity funds had $7.6 billion in outflows, while active funds shed just $700 million. This is a break from the 12-month trend, as active funds lost nearly $28.9 billion to outflows while passive funds shed about $13.0 billion. Overall, this is the first major category group where passive funds have overtaken their active counterparts in total assets. Passive sector equity funds have 54% market share versus 46% for active funds.

Weak passive flows were also reflected in exchange-traded funds, which are mostly passive and took in just $2.5 billion overall versus $36.6 billion for their open-end counterparts. Such a big edge for open-end funds (including both active and passive funds) is rare these days as ETFs have come to dominate inflows. January was the first time since March 2018 that open-end funds enjoyed stronger inflows, and the $34.1 billion advantage in flows was the greatest since March 2014. Over the past 12 months, open-end funds had $184 billion in outflows versus ETFs' $240 billion in inflows.

Other key takeaways from this month's report include:

• Taxable-bond funds stormed back with $31.5 billion in inflows, the group's best month since January 2018. In contrast to passive equity, passive taxable-bond funds thrived with a record $27.6 billion.
• International-equity funds also bounced back with $14.2 billion after roughly equal outflows in December, likely owing in part to tax-loss selling. Diversified emerging-markets funds were the big winners with $10.8 billion in inflows, the Morningstar Category's best month since January 2018.
• Vanguard dominated with about $19.7 billion in inflows. The mild surprise was the weak performance of iShares, which collected just $400 million, the firm's worst showing since June 2018. Its U.S. equity funds suffered a firm-record $13 billion in outflows.