In Morningstar’s recent Rekenthaler Report, “Do Active Funds Have a Future,” John Rekenthaler considers the future of active management. His short answer: “Apparently not much.” Rekenthaler reports that net sales over the past 12 months for all exchange-traded funds, passive mutual funds and active mutual funds break down at 68% passive, 32% active.
The article goes on to state that if target-date fund flows are excluded ($30BB of $100BB in net sales of active funds), the picture gets even worse. Apparently, the fact that “target-date funds sell into a captive audience that must purchase funds from the target-date family that is placed in front of it,” Rekenthaler writes, makes those sales “accidental.”
The article summarizes its conclusions by stating that “there is core and then there is explore … active management is no longer core.”
There are quite a few factors driving the shift from passive to active:
• There has been a steady shift away from individual security selection to asset allocation, based on the fact that the latter has a much bigger impact on return than the former.
• The rise of smart beta investing is taking up much of the space formally occupied by alpha-seeking funds. This is in spite of the fact that the term “smart beta” is probably nonsensical given that beta is beta, regardless of the rules — be they commercial or custom — that determine the makeup of a given index fund.
• The emergence and popularity of ETFs — which, as the Morningstar article reports, have a 35% share of net new sales, as opposed to passive at 33% and active at 32% — is expanding the passive footprint. Most ETFs are based on some sort of indexing strategy.
• Fees — both explicit (operating expense ratio) and implicit (internal trading costs) — have increasingly been brought into the spotlight. It seems that the market is saying that the expense associated with the search for the holy grail of alpha is not worth the cost of the expedition.
• As the markets shift into a lower return world (especially in bonds), the impact of fund expenses can have a greater negative impact on returns — thus making a stronger case for low-cost passive options.
• Investing passively requires less investigative work — asset size, expense, index type and tracking error constitute the basic information needed to compare passive vehicles.
• The notion that an active fund has less than a 50% chance of meeting or exceeding its benchmark has become a widely held belief among both institutional and retail investors. Bill Sharpe’s “arithmetic of active management” has, in essence, gone mainstream.
Conclusion
Plan advisors have seen the shift from active to passive from a front-row seat, so for most, the Morningstar article offers no surprises. Advisors have actually been at the forefront of promoting passive investing while focusing more of their efforts on asset allocation funds, managed accounts and investment advice.
It is interesting when some advisors promote low-cost passive investments and consider their approach to be “disruptive.” In fact, as Rekenthaler points out, it has become a “core and explore” investing environment, with active being non-core.
A better approach, it seems, is to focus on improving investor outcomes. While fund expenses and performance are important factors, outcomes are driven primarily by whether or not a given DC investor is in a risk-appropriate asset allocation fund, model or managed account and is making sufficient contributions to achieve his or her retirement income goal.
