2017 was the year of massive inflows into passive funds, according to Morningstar’s annual fund flow report, which covers mutual funds and ETFs. The report highlights that a total $692 billion flowed into passive funds, led by U.S. equity and international equity funds. Conversely, almost $7 billion flowed out of actively managed funds, which was far less than outflows in the previous two years. That’s a pretty significant trouncing by passive in the annual fund flow race.
For years, investors have made the case that the most efficient asset classes make the most sense to index. We all know the argument, “Why pay up for active management in asset classes where there are no anomalies for an active manager to exploit?” Many investors embrace low cost index investments. Case in point, Vanguard, the proverbial champion of the passive investing movement, is one of the largest asset managers in the world. However, over the years, many RIAs and institutional investors still believed that certain segments of the market harbored some inefficiencies and active management could outperform net of fees. Morningstar’s fund flow data suggests the tides are shifting toward passive across the board.
At R Squared, we are active managers in international equities investing in both developed and emerging markets. With that statement, we are inherently biased towards active management in the active passive debate. We understand that managers have periods of outperformance and periods of underperformance, just as markets do. Trends ebb and flow. With the S&P 500 posting a positive return every year since 2009 and international markets positive 6 of the last 9 years, passive investing seems an easy choice. It’s even easier when market volatility has all but vanished. When markets normalize, volatility returns, and passive investors begin to see their account balances declining, we can’t help but wonder if active managers will come back into fund flow favor. As bottom-up stock pickers who are more focused on fundamentals than macro, the environment we are in now is challenging. When risks actually result in downside performance versus lying dormant under the surface of positive performance, active managers have the opportunity to demonstrate capital preservation.
So fund flows for 2017, passive wins. What about total assets? The edge there goes to actively managed funds which as of the end of the year stood at $11.4 trillion compared with $6.7 trillion for passive funds.
The numbers for active managers may be changing, but we know markets are changing too. 2018 is a new year and just maybe it will be the year of active managers.