ETF Edge

The success of passive investing comes down to one thing, experts say: Fees

Passive investing is beating active—what that could mean for ETF investors
Passive investing is beating active—what that could mean for ETF investors

In this market environment, the ongoing passive versus active investing debate really comes down to one thing, experts say: fees.

Passive funds — including both exchange-traded and mutual funds — surpassed active funds in terms of assets under management in September, according to Morningstar, with passive funds racking up about $4.37 billion in assets by the end of the month and active funds attracting about $4.27 billion.

Actively managed stock funds based in the United States also saw their eighth straight month of outflows in September, Morningstar reported, adding that those types of funds have only seen two months of inflows since March 2014.

"People have learned that it's hard to find active funds that consistently deliver alpha," Deborah Fuhr, one of the world's leading experts on exchange-traded funds and the founder of ETFGI, said Monday on CNBC's "ETF Edge."

Alpha refers to a given investment strategy's ability to beat the broad market.

"If they do it one year, they're not likely to do it next year or the following year," Fuhr said. "On average, 7 out of 10 active funds do not beat the S&P 500 if they're a large-cap active fund here in the U.S., and the same is true if you go around the world."

As such, investors are turning to lower-cost products, ones that may seem less trendy or industry-focused, but are less likely to jeopardize their long-term gains, Fuhr said.

"Investors have learned [that] buying lower-cost products deliver[s], over a long run, better returns for you," she said. "So, if it's hard to find active funds that consistently deliver alpha, go to an index product like an ETF and get the benchmark and get alpha through asset allocation. ... You're seeing people use ETFs to overweigh countries, sectors, regions, and generating alpha through that. So, they use a barbell approach to investing."

While they aren't all passive vehicles, ETFs offer more cost- and tax-efficient ways for investors and money managers to get more niche or curated exposure, Fuhr said, partly solving for the issues inherent in costly, often-underperforming active funds.

"There's going to be some significant benefits from active being inside of the [ETF] Wrapper, but ... if you're not a good alpha generator as an active mutual fund, you're not necessarily going to be a good one as an ETF [manager]," Fuhr said.

"That's why, when the first active ETF came to market with the ticker YYY, the resounding chorus was, 'Why do we need active ETFs?'" she said. "Now, we do see that many asset managers feel they need to have an ETF strategy, and so, many are deciding, 'Where should I offer ETFs? Where does it make sense?' And so they're jumping on the bandwagon."

Steve Grasso, managing director of institutional trading at Stuart Frankel, agreed with Fuhr on the main driver of the preference for passive.

"I think you bring up a great point: it's about fees, and a lot of this stuff is about ... how [you can] get the cheapest execution," he said Monday in the same "ETF Edge" interview. "If you're going to have a bad stock pick, you might as well not pay, on top of it, a boatload of fees. When you see this push into passive investing, it's about the fees."

DataTrek Research co-founder Nick Colas said in the same interview that there's also a big-picture reason for investors' push into passive funds.

"The biggest issue is, when the mutual funds were growing from 1980 to 1999, the S&P compounded at 18% a year," the data specialist said. "Last 20 years, it's been 6%. So, we've had a third of the returns, structurally, that we had from the early '80s, and that's why you need passive management, to not pay those high fees because you can't afford it."