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'Peak passive'? Money is gushing out of actively managed funds

Investors bailed on actively managed funds in record numbers during 2016, preferring the reliability and low costs of index funds over taking a chance on finding a stock picker who could beat the market.

Amid one of the worst years ever for stock pickers, passive funds took in more than half a trillion dollars — a record $504.8 billion to be exact — according to Morningstar data released this week.

When it came to funds that focused on U.S. stocks, there was nearly a dollar-for-dollar switch: Passive funds brought in a record $236.7 billion in investor cash, while their active counterparts saw $263.8 billion go out the door, worse even than the $208.4 billion in outflows during the height of the financial crisis in 2008.

That doesn't even count the more than $100 billion that left hedge funds during the year.

In addition, December saw passive funds bring in a one-month record of $50.8 billion, while active witnessed redemptions of just more than $23 billion, marking the 33rd consecutive month of outflows.

The trend comes amid an intensifying debate over active vs. passive.

"If you use the magazine headline indicator, then certainly we are at peak passive." -Nick Colas, chief market strategist, Convergex

Active is represented primarily by the $13.5 trillion mutual fund industry, which is populated heavily with managers who move in and out of positions to try to beat market benchmarks such as the S&P 500. On the other side, the $2.4 trillion exchange-traded fund industry tracks indexes with offerings that carry much lower fees and trade like stocks, providing more liquidity than mutual funds.

Active mangers haven't done much to boost their cause. Just 19 percent beat the large-cap Russell 1000 in 2016, according to Bank of America Merrill Lynch, giving further fuel to the exodus.

"Certainly for the smaller investors and the long-term investors, the passive strategies are more comfortable and seem to make more sense," said Carol Roth, partner at Intercap Merchant Partners. "The active traders have not proven that they're worthy of the allocations."

All the money flowing toward indexing, though, has generated some critics who believe passive investors are ignoring risks. Passive investing offers fewer opportunities to generate "alpha," or the ability to beat benchmarks, and offers little downside protection. When the market falls, investors tracking indexes can lose money unless they're properly diversified.

The question, then, is whether the investing community is reaching "peak passive" — a high-water mark for the popularity of passive funds.

"If you use the magazine headline indicator, then certainly we are at peak passive," said Nick Colas, chief market strategist at Convergex. "Everyone has chiseled out the tombstone for active management."

Colas believes conditions are changing that could lead to better times for active managers.

Specifically, he said correlations, or the tendency of stocks to move up and down together, are breaking down after years of exceeding 90 percent. The prevalent correlation trend has made it difficult for stock pickers to find the price differences that lead to alpha generation.

With market volatility increasing, that could lead to better conditions for active management. Indeed, the year closed with a somewhat better performance, as 37 percent of managers beat the benchmark in the fourth quarter, according to BofAML.

"The missing piece is going to be more active managers outperforming. That's going to take time only because we literally just had the breakdown in correlations two months ago," Colas said. "Investors will want to see at least a quarter or two of outperformance before they start shifting allocations."

Don't look to Trump for help

They may get an assist from central banks.

The Federal Reserve and other global central banks have contributed to the tough climate for active managers as liquidity policies have kept market volatility low. But the Fed is expected to raise interest rates multiple times this year, and others around the world are contemplating their exits from collective monetary policy that is at record levels of accommodation.

"One could say that perhaps central banks have actually underpinned the performance of passive funds," said Quincy Krosby, market strategist at Prudential Financial. "But if you have the European Central Bank, if you have the Bank of Japan beginning an exit from easy money, tightening liquidity, that also introduces more volatility."

The industry is hoping that increased volatility, higher rates and opportunities created under President-elect Donald Trump will make for a more welcoming landscape.

However, the ability of active mangers to outperform remains in doubt.

"As an investor, what makes you think now all of a sudden (active managers are) going to have keen insight about what Trump's actions or potential actions are going to be or are going to mean?" Roth said. "That may sound like a great sales pitch, but in reality you have to evaluate the data, and that says a lot of people don't know."