Grim milestone for active management

The month of May is about to usher in a significant milestone for actively managed mutual funds, and not a favorable one.

The trends suggest passive U.S. equity fund assets will gain a majority of market share for the first time ever over actively-managed U.S. equity mutual funds and exchange-traded funds this month, after coming close in April.

For some context, consider that just 10 years ago, active U.S. equity funds had a dominating 75% share of the market. At the end of April, that advantage had shrunk to 50.04%, and all the momentum is on the side of passive funds.

“It’s probably already happened,” said Morningstar analyst Kevin McDevitt.

According to Morningstar, through April the total assets in passive U.S. equity funds trailed by just $6 billion the $4.31 trillion in active U.S. equity funds, thanks to a month that saw $39 billion of net flows into passive funds and $22 billion in net outflows from the active funds.

The point at which passive officially gains the market share advantage over active is significant not because the asset management industry couldn’t see this coming for the past two decades, but because the trend is not expected to reverse. Ever.

“Active management is losing ground to two overlapping trends, which are the trend toward passive investing and the trend toward ETFs,” said Todd Rosenbluth, director of mutual fund and ETF research at CFRA. “I don’t think the tide is going to turn back toward active management.”

Because indexed-based funds represent 98% of the $3.9 trillion ETF market, the trends toward passive investing and toward ETFs are often viewed as one and the same. But they actually represent two separate assaults on the active-management space.

It would be easy to write off active management’s shrinking market share over the past decade to a bull market that has seen the S&P 500 Index stack up a 12.44% 10-year annualized return.

While it is surely a factor that low-cost indexing is the most efficient way to ride a rising market, the bull market argument loses steam when you look at how financial advisers and investors have continued to move from active to passive even during market pullbacks.

“This is a secular trend that seems to be independent of what’s happening in the markets,” Mr. McDevitt said. “During the credit crisis, we saw flows into passive funds pick up, and that’s when active funds are supposed to do well. And we saw the same thing during the pullback in the fourth quarter of last year.”

Steven Skancke, chief economic adviser at Keel Point, said that in many cases, active managers have been hurting themselves by tending to track the indexes, which makes it even harder to beat a benchmark.

“While the current market environment gives [active managers] an opportunity to recapture the high ground of superior performance, the general trend is already so deeply set that it is unlikely that they can reverse the movement from active to passive investment management strategies,” Mr. Skancke said.

In theory, active management has one important edge over a passive approach in a declining market, which is the ability to hold cash, while passive funds are forced to keep buying every underlying security in the index.

It might take a major and prolonged pullback for that advantage to start moving the needle toward active management.

“Here at Morningstar, we’ve been saying for 20 years that active management needs to find a way to reinvent itself and change its value proposition if it wants to survive,” said Mr. McDevitt. “Traditional stock picking, charging 1% and trying to beat the market is not working anymore.”

Related Topics: Morningstar Inc.