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Passive investing set claim half of markets

Passive investors could control over half of US stock and bond markets by 2021, according to Moody’s research — a trend that is illustrated by the strong start to this year for exchange traded funds. 

US actively-managed funds faced net outflows last year of $340bn as investors poured $505bn into passive products such as ETFs that track indices, according to data from Morningstar, a research service. 

The momentum has continued into 2017, with US exchange traded products garnering inflows of $40.1bn in January, marking an increase from the $26bn monthly average from last year, ETF.com data show. 

The shift is poised to accelerate further, bringing the US market share of passive products to more than 50 per cent over the next four to seven years, from 28.5 per cent today, said analysts at Moody’s Investors Service. 

Penetration of passive products outside America has been far less vigorous, with market share in the rest of the world sitting at roughly 5 to 15 per cent. However, as global developed and emerging markets mature, “there will be opportunities for broader expansion”, Moody’s said.

“Investor adoption of passive and low-cost investment products will continue irrespective of market environments,” added Stephen Tu, an analyst at Moody’s. 

In recent years, growth in ETFs has been led by equities markets with the most liquidity, or a high concentration of buyers and sellers willing to trade shares. But Moody’s expects advances in indexing and ETF technology would “eventually be applied to more public asset classes”. 

Indeed, in a sign of the widening breadth of passive investments, flows into international equity and US bond funds were $12bn each last month, not far behind the $15bn that went into ETFs that track US equities, according to ETF.com. 

The expected expansion of passive products comes as active managers, which hand-pick investments, have struggled overall to provide superior returns.

Indeed, only one-in-five mutual fund managers that invest in large US companies beat their benchmark last year, compared with 41 per cent in 2015, according to Bank of America Merrill Lynch. A separate report from Birinyi Associates, which focuses on US equity funds that have been in business at least five years and had more than $1bn in assets, found that about a third outperformed in 2016. 

The lacklustre performance is problematic since active managers charge heftier fees for their services. US large-cap stock mutual funds have an expense ratio of 52.1 basis points on an asset-weighted average that gives bigger funds greater influence, Morningstar data indicate. 

That compares with 13.1bp for ETFs tracking the same types of shares. Removing the asset weighting illustrates an even starker difference, with active funds charging 109bp compared with 35.1bp for ETFs.

Active asset managers “argue that underperformance has been driven by the benign post-crisis economic backdrop and extensive central bank intervention”, noted Nathan Flanders, a managing director at Fitch Ratings, in a report this week.

Mr Flanders added that the situation has led to an environment where “virtually all asset classes move in a more correlated fashion, diminishing active managers’ ability to outperform”. 

However, he believes a correction, defined as a 10 per cent fall in asset values, could somewhat counter-intuitively provide a boon to actively-managed funds. 

“Passive funds would follow their respective benchmarks down, while those active-oriented traditional investment managers able to better navigate the stress could see better results and attract asset inflows thereafter,” he said. 

Even if active funds did not manage to outperform their benchmarks, the ructions would “provide a reminder to investors that passive strategies do not always move upwards”, he added. 

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