Investors Still Pouring Money Into Passive Funds

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. U.S. passive-fund market share hit 40% in the first half of 2019. Joining me to discuss some themes from Morningstar's fund flow data is Kevin McDevitt. He's a senior analyst in Morningstar's manager research group.

Kevin, thank you so much for being here.

Kevin McDevitt: Thanks for having me, Christine.

Benz: Kevin, let's discuss this passive flows juggernaut. It's something that you have been observing for a number of years. And really, it continues unabated, where we see investors very strongly indicating that they're preferring passive products.

McDevitt: Yeah, and it's really across the board. I think for a while people thought it was really just kind of confined to equity funds, and U.S. equity funds, in particular. But it's really across the board. It's all asset classes, maybe with the exception of municipal-bond funds.

Benz: So, you think that this is largely driven by the fact that the complexion of fund ownership is changing a little bit underneath the surface. So, you've got more managed portfolios that are making decisions, you've got more advisors making decisions on behalf of investors. Let's discuss some of those secular forces that are driving the interest in the assets into passive products.

McDevitt: Yeah, I think that's really a huge part of it, what you identified there with that interest in managed portfolios, whether you're talking about an advisor putting a client into a managed portfolio, or an individual investor investing through a target-date fund, a lot of those portfolios are using passive products. You see that demand in just kind of what's--if you look underneath the asset classes and look at categories, you can see that all the demand for U.S. equities going into large blend, again, kind of that core strategy. With international equity, all net demand is going into foreign large-blend funds, again, a core holding. Diversified emerging markets, which I think are a bit of an anomaly, but I think that's reflected in the fact that a lot of advisors see emerging markets as somewhat of a separate asset class. Within taxable-bond funds, again, you see intermediate-term core bond, intermediate-term government, all those core strategies, that's where all the net flows are going.

Benz: So, it's not just that investors are saying no to active. They're saying no to some of the satellite holdings that perhaps they used in the past. So, they're not using large-growth and large-value indexes. They're just saying, I'm getting my U.S. equity exposure via this total market index, for example.

McDevitt: Right. Although, to be clear, they are saying no to active as a part of that process.

Benz: Absolutely.

McDevitt: But yes, I think that's really the underlying theme there.

Benz: And you say that the fact that some of these decisions are being driven by different entities, not just individual investors themselves, has kind of changed the behavior before our very eyes, where we used to kind of see this performance-chasing fund investor, we're in some cases, seeing kind of contrarian patterns. Let's talk about that.

McDevitt: It's really a stunning development. As you and I both know having been in the industry a long time, it's such a different world from what you saw perhaps 20 years ago, a long time ago. But back in the day, during the first dot-com bubble the way investors would throw money at whatever hot manager was new on the scene, you don't see that really at all now. And again, kind of that contrarian piece you mentioned. So, in the fourth quarter of last year, when you had a pretty serious correction, U.S. equity funds actually had inflows about $50 billion. But then you look at this year, where you've had a very strong market, the S&P is up, what, 20%, 21%. But inflows for the first half of the year are only about $17 billion. So, far less demand this year when the market is way up, compared to the fourth quarter of last year when the market was way down. So, it's really a stunning reversal. I think that again speaks to just the power of these managed portfolios, how investors aren't focused on returns, which is a positive.

Benz: So, if I own a target-date fund and my manager is buying and selling on my behalf, one thing that might be happening with the equity piece is, if they're targeting, say, 60% equity for that portfolio and stocks go down, they are buyers in that environment.

McDevitt: Yeah, exactly. I think that's exactly the dynamic. It's rebalancing that's driving demand rather than performance.

Benz: How about in fixed income? Are you seeing kind of a similar pattern prevail? What are investors doing in terms of their fixed-income choices? Do you see a similar sort of contrarian mindset? Or is it a little bit different?

McDevitt: For the most part, the strongest flows are still going into those core strategies, those core categories. So, again, intermediate-term bond, whether it's government or kind of broader-focused, you may be investing in some credit, too, those are the strongest categories. But you do see more breadth with taxable bonds. So, you are seeing strong demand, for example, with high-yield bond funds. I think they've got about $15 billion or so this year in inflows. So, that's the only area where you're seeing some breadth in terms of demand is taxable bond.

Benz: And how about the active/passive bifurcation there? Are you seeing the same theme where investors are generally going with the indexes? Or are they giving a little more room to active managers here?

McDevitt: Passive is still dominating there. Although you are seeing some flows going into active. And again, to the extent that credit-oriented strategies are doing well, those tend to be more on the active side. So, I think of like PIMCO Income, which is kind of a quintessential active strategy, it's a multisector bond fund. It's got about $14 billion in inflows to lead all active bond funds this year. But I think that's partly driven by the fact that credit is doing pretty well this year. So, you're seeing some flows to active bond funds, but overall, passive is still dominating there.

Benz: And then, in terms of the providers that have been thriving in this environment, it's all the passive shops that you think of, right?

McDevitt: For the most part, although kind of one--I mean, you're right, all the demand is certainly coming from the passive side, with Vanguard leading the way, close to $100 billion or so in inflows so far this year, iShares has been very strong with about $60 billion. But right there is Fidelity, which, again, for those who've been in the industry a long time, it's weird to think of Fidelity doing well, but it's all their passive products that are doing well.

Benz: Because we think of them as an active shop, but they are selling a lot of passive stuff, and they do a good job on managing passive investments.

McDevitt: Correct. And you're right. I mean, all the demand is on the passive side. Their active strategies on balance are in outflows.

Benz: Kevin, always great to get your perspective, kind of explore this intersection between investor behavior and what we're seeing and where they're putting their dollars. Thank you so much for being here.

McDevitt: Thank you, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.