Personal Finance

Investors say 'forget it' to active funds


Investors have not been kind to actively managed funds since the financial crisis.

Poor performance by active managers has caused investors to move money out of actively managed funds at record levels this year.

Active fund managers have seen outflows accelerate for the past four years and hit record extremes in the first seven months of 2016, according to Bank of America Merrill Lynch analysts in an Aug. 29 research report. (See chart below.)

As the S&P 500 reached all-time highs, the performance of funds that invest in large-company stocks is at an all-time low with only 14 percent of active managers beating their benchmark so far this year, the BofAML analysts found.

The dominance of index funds has some supporters of actively managed funds worried about its long-term effects on the economy.

"A Marxist economy where investment is centrally planned is a plausible alternative but less efficient. However, a supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market-led capital management," a Bernstein research team wrote in a note titled "The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism."

The heated rhetoric may just be sour grapes.

"More investors are saying that 'If indexing is socialist, I don't want to be a capitalist,'" said Ben Johnson, director of global ETF research for Morningstar.

Still, investors have a long way to go before they throw off the "captialist" shackles of actively managed funds. About one-third of all assets under management use passive strategies and 40 percent of the money invested in the U.S. stock market is through index funds.

And yet, a recent Morningstar analysis found that a majority of actively managed funds across all asset classes failed to beat their passively managed counterparts over a 10-year period through June 30. (See chart below.)

Active funds struggle against passive funds in flush times because of Dunn's Law: "When an asset class does relatively well, an index fund in the asset class does even better. In contrast, when an asset class does poorly, the active managers do better in that asset class."

The maxim was coined by portfolio strategist Steven Dunn in the 1990s to explain why active funds lagged their benchmarks during the bull market.

Morningstar's analysis of active and passive funds supports Dunn's theory. For example, active value fund managers suffered in their short-term success rates against value index funds because value stocks have performed well over the past year.

Meanwhile, the long-term success rates of active managers against passive funds were higher for funds that invested in asset classes that have performed poorly over the past three years, such as those that invest in emerging market stocks.

Active funds also face tail winds when it comes to beating index funds because of higher fees. Last year, the asset-weighted average expense ratio for passive funds was 0.18 percent compared with 0.78 percent for active funds, according to Morningstar.

Investors have taken notice.

In 2011, passive funds gathered $140 billion more than active funds. Last year, passive funds took in $576 billion more than active funds. That's an impressive feat when you consider there are eight active funds for every passive fund.

Lower fees, as opposed to better performance, may be the big reason more investors are switching from active to passive. Morningstar found the investors in active funds improved their odds of beating passive funds by favoring funds with lower-than-average expense ratios.

"It's not so much about active versus passive as it is about fees," Morningstar's Johnson said.