2017 is active managers' 'last chance' to stop the ETF takeover, analyst says

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Even after the election of pro-business candidate Donald Trump unleashed a flight out of bonds and into stocks, active mutual funds lost out.

While exchange-traded funds raked in big money since the election, actively managed funds posted their third-worst month for outflows in history in November.

2017 is their last chance to stem the tide, according to Jefferies analyst Daniel Fannon.

"The environment for active managers to outperform benchmarks has been challenging for many years now," wrote Fannon in a note to clients Wednesday.

"However, with 2017 shaping up to be a year of higher interest rates and volatility, there is the potential for higher dispersion amongst stocks and sectors. This represents the last chance for active managers, who tend to have a quality bias in their asset selection, to try and outperform and slow down the migration to passive."

The asset manager stocks have beat the market since the election so there appears to be some optimism that they have a fighting chance to make a comeback. T. Rowe Price is up 21 percent, Franklin Resources has climbed 16 percent and Invesco shares have rallied 10 percent since Nov. 8.

This chart from Jefferies shows what the active fund industry is up against:

active melloy

Source: Jefferies, ICI

That's the drop in market share for active funds versus ETFs and index funds over the last 22 years.

That continued in November as active-managed retail funds lost $68 billion, while $51 billion flowed into ETFs, according to Jefferies. That loss brings the active group's outflow total to $261 billion for 2016, the note said.

"As we look ahead to next year, we believe the fate of the group rests perhaps more on the evolution of the macro environment than at any other point in recent history," wrote Fannon. "While the backdrop appears to be trending more positively vs. pre-election, the size of the fiscal stimulus package, the extent to which taxes are reformed and the degree to which regulatory burdens are reduced are all likely to have a meaningful impact on returns."

"Our top pick for 2017 is TROW (T. Rowe Price), which stands to benefit from the majority of trends we see developing over the next year," the analyst added.

Most notably, a possible rollback of the Department of Labor's fiduciary rule under a Trump-led government will be a key positive development for the industry, Fannon said. The rule, set to be implemented in April, could curb sales of mutual funds by brokers by requiring them to act always in their clients' best interests for retirement accounts.

"Gross sales were negatively impacted in a meaningful way this past year with the introduction of the DOL's fiduciary rule. While the ultimate fate of the legislation is unclear (i.e., will the new administration suspend the rule prior to go live in April or let it go into effect), the shock the industry received from its unveiling will likely subside as the industry finalizes the processes and procedures to deal with the new rules," the report said.

However, it all still comes down to stock picking, according to Fannon.

"Additionally, if active begins to see an improvement in performance as 2017 progresses, the optics alone (e.g., more positive media coverage) could have a positive impact on investor sentiment and their willingness to give active one more try."