FA Playbook

Investors pouring billions into passively managed funds

Andrew Osterland, special to CNBC.com

Markets are volatile and investors are nervous, thanks to the Brexit vote in the U.K. and the American presidential horse race. Amid all the uncertainty, the three big advantages of passively managed exchange-traded funds — they're cheap, flexible and tax-efficient — continue to drive the migration of investment assets from actively managed mutual funds to ETFs.

Many industry observers had expected that increased market volatility would push investors back to active managers, but the latest asset-flow stats from research firm Morningstar suggest not. In May, $18.7 billion flowed out of actively managed U.S. equity funds and $8.1 billion flowed into passively managed ones that track an index — largely ETFs.

In the last year, all categories of long-term active funds lost a staggering $308 billion, while passive funds (again, largely ETFs) attracted $375 billion.

Yuri Arcurs | Getty Images

"It's not a question of whether the trend continues but at what pace," said Ben Johnson, global director of ETF Research at Morningstar. "We're seeing a wholesale shift away from actively managed funds to passively managed ones."

The shift is occurring in all corners of the market, from institutional buyers to intermediaries to self-directed retail investors. It's occurring across all asset classes and geographic markets.

"There's an unquenchable thirst for ETFs across all segments of the market," said Martin Small, head of U.S. iShares at BlackRock, the largest ETF asset manager. "When every penny counts, ETFs let you keep more of what you earn."

Fee-based registered investment advisors have been among the more enthusiastic users of ETFs in the last decade. A recent survey of 283 financial advisors by the Financial Planning Association found that 83 percent were now using ETFs to invest client assets — slightly higher than mutual funds (80 percent). That's up from just 40 percent in 2006. Nearly half of those advisors plan on increasing their use of ETFs in the next 12 months.

"We're seeing growing numbers of financial advisors incorporating more passive approaches in their portfolio construction," said David Yeske, co-founder of RIA firm Yeske Buie and practitioner editor of the FPA's Journal of Financial Planning. "The number of indexes tracked by ETFs has grown enormously, and you can build any portfolio you want using them."

Investors have become more familiar and comfortable with fixed-income ETFs. They're using them to build out larger parts of their portfolios.
Ben Johnson
global director of ETF Research at Morningstar

Ric Edelman, head of RIA Edelman Financial, has been using ETFs for more than a decade. He said the explosion of funds tracking smaller indexes, industry sectors and slices of different markets has given investors plenty of opportunity to trade ETFs actively.

"I wouldn't endorse actively trading ETFs," he said. "We don't do sector rotations or buy narrowly focused products, but we have about 50 percent of client assets in ETFs." Edelman also uses low-cost mutual funds from Dimensional Fund Advisors and Vanguard Group.

Low cost is the most significant advantage of ETFs. The average asset-weighted cost of all investment funds fell to 0.61 percent last year, from 0.64 percent in 2014, largely due to asset flows into low-cost ETFs and index mutual funds. The average cost for passively managed funds — virtually all ETFs track an index — was 0.18 percent vs. 0.78 percent for actively managed funds, virtually all of which are mutual funds.

ETFs are more tax efficient than mutual funds, because they don't have to distribute capital gains to investors when they sell securities — all the more important with the rise in capital gains tax rates. ETFs also give investors more trading flexibility, allowing intraday trading, while mutual fund transactions occur at the net asset value calculated at the end of the trading day.

Fixed-income securities are the latest huge market opportunity for the taking. In the ultra-low interest-rate environment, it appears that the low costs of ETFs are now outweighing criticisms that fixed-income indexes are not well constructed or easy to track.

Many also believe that credit research in the bond market gives active managers a bigger opportunity to outperform benchmarks. That's the chief reason that most of the money in municipal bond funds, currently one of the hottest segments of the fund industry, is in actively managed mutual funds.

It appears, however, that investors are getting over those worries in much of the bond market. Over the last year, actively managed taxable bond funds have lost $80 billion in assets, while passively managed bond funds have taken in more than $108 billion.

"Investors have become more familiar and comfortable with fixed-income ETFs," said Morningstar's Johnson. "They're using them to build out larger parts of their portfolios."

Again, the reason is low cost. "You can own the entire bond market for 8 basis points," said BlackRock's Small, referring to the cost of his firm's market-leading AGG bond fund, which tracks the Barclay's Capital Aggregate Bond index. It currently manages $37.7 billion in assets. "We've reached a tipping point where the facts have overwhelmed the criticism [of bond ETFs]."

There are currently about $2.2 trillion in assets in ETFs — roughly 15 percent of the market for retail investment funds. Small expects growth rates to be 10 percent to 12 percent annually for the next decade and total ETF assets to reach $9 trillion by 2026.

"We will be able to index so much more of the capital markets, and ETFs will expand into every asset class that can be indexed," he said.

— By Andrew Osterland, special to CNBC.com