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A seismic shift is happening, and billions are pouring into these index funds and ETFs

Stock pickers with seven-figure salaries may view President Donald Trump's opposition to the Department of Labor's new fiduciary rule as a saving grace. In reality, it's just a stay of execution.

In the past decade, there's been a seismic shift from active to passive management, i.e., from mutual funds run by ersatz Peter Lynches to index funds and ETFs that track the market.

The fiduciary rule, which President Obama first advocated for in February of 2015 and the DOL formally proposed on April 14, 2016, accelerated that trend. If implemented, it would impose "impartial conduct" standards on financial advisors requiring they always act in their clients' best interests. That means finding the best investment fund possible, while the older, "suitability standard" required only finding an acceptable option for an investor's given risk tolerance. The best option, reams of academic studies have confirmed, is generally the low-cost one. And the lowest-cost funds are index ones.

In anticipation of the rule change, assets have flocked to index funds, driven by the cultural shift in the financial advisory community. Flows out of actively managed U.S. equity mutual funds leaped to $264.5 billion in 2016, while flows into passive index funds and ETFs were $236.1 billion, according to data provided by the Vanguard Group and Morningstar. That was the greatest calendar-year asset change in the last decade, during which more than $1 trillion has shifted from active to passive U.S. equity funds.

But now, at Trump's behest, the DOL has postponed implementing the fiduciary rule, which was slated to go into effect this April, and is reviewing it. It's possible the rule will be revoked completely, or changed so the impartial conduct standard is significantly weakened.

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Yet money is still flowing in the wrong direction. In the first two months of 2017, active U.S. equity funds lost $30 billion, while passive gained $60 billion. Although the rule may be reversed, that won't change the ongoing shift in the advisory model. "For some time financial advisers have been shifting from a commission-based structure to a fee-base structure," says Todd Rosenbluth, director of ETF and mutual fund research at CFRA. "Lower-cost index products fit nicely into that model."

What's driving the trend

In other words, while in the past advisors might receive a 5 percent commission on the sale of a popular active fund, now they work on a percentage of assets under management, usually 1 percent for a traditional financial planner. As that 1 percent fee is ongoing, as opposed to a one-time commission, buying cheap index funds to go with it makes the financial advice affordable, Rosenbluth says. "It allows advisors to get paid."

Biggest ETFs gaining ground

Largest 10 ETFs
Ticker
Morningstar Category
Expense Ratio %
Net Assets - $ Billions
Total Return Annlzd 5 Year
SPDR S&P 500 ETF SPY US Fund Large Blend 0.10 233.8 13.27
iShares Core S&P 500 IVV US Fund Large Blend 0.04 102.2 13.34
Vanguard Total Stock Market ETF VTI US Fund Large Blend 0.05 75.9 13.22
iShares MSCI EAFE EFA US Fund Foreign Large Blend 0.33 67.2 6.21
Vanguard 500 ETF VOO US Fund Large Blend 0.05 63.6 13.36
Vanguard FTSE Emerging Markets ETF VWO US Fund Diversified Emerging Mkts 0.14 52.2 1.13
Vanguard FTSE Developed Markets ETF VEA US Fund Foreign Large Blend 0.09 47.8 6.76
PowerShares QQQ ETF QQQ US Fund Large Growth 0.20 46.9 15.67
iShares Core US Aggregate Bond AGG US Fund Intermediate-Term Bond 0.05 43.6 2.29
iShares Core S&P Mid-Cap IJH US Fund Mid-Cap Blend 0.07 38.8 13.28
Source: Morningstar as of April 10th, 2017

Of course, cheap isn't always good. Active managers have long argued that indexing the market is settling for mediocrity. "If the average mutual fund is still underperforming the index, mediocrity is still better than below average," Rosenbluth counters. Indeed, 67 percent of all active equity funds have underperformed their benchmarks in the past decade through Dec. 31, 2016, according to Vanguard and Morningstar. And that's just for funds that continue to exist. If you account for liquidated funds — what is known as "survivor bias" — the lagging number jumps to 86 percent.

Part of the problem is that markets may be more efficient than previously. "It's getting harder and harder for managers to outperform," says Thomas Rampulla, head of U.S. Financial Intermediaries at Vanguard. "There's been a real professionalization of the asset management industry on the active side." He points out that 50 years ago only about 20 percent of assets were professionally managed, while today 68 percent of assets are.

That makes it difficult for professionals to get an edge when they're competing with so many other sophisticated investors.

It's all about fees

Yet a bigger issue is most managers are still charging too much. One 2016 study by fund company Fidelity found that from 1992 through 2015, active U.S. large-cap stocks funds in the lowest quartile of fees from the largest five fund families beat the benchmark by 0.18 of a percentage point a year on average.

Meanwhile, the average active fund lagged the benchmark by 0.71 percent.

There may also be a cyclicality to manager underperformance. Brian Hogan, who oversees some $900 billion as president of Fidelity's equity and high-income division, believes the post-2008 financial crisis era has been particularly tough for active managers, as monetary stimulus from global central banks has driven stocks uniformly upward, making it harder for active managers to differentiate themselves.

But since the U.S. Federal Reserve ended its stimulus program in October of 2014 and began raising interest rates in 2015, Hogan says the environment has changed. "That backdrop is becoming very helpful to the active industry," he says. "It's causing there to be less correlation among stocks and more dispersion in their performance. Those are things active managers like to see. I think the next three to five years are going to be really fun for the active industry."

The highest-paid managers better hope he's right, because if the current trend continues, they won't be around much longer.

— By Lewis Braham, special to CNBC.com

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