The fourth quarter of 2018 may be a turning point in the history of investment management. Tired of paying high fees for performance that consistently lags the market, investors pulled a record $313 billion from actively-managed U.S. mutual funds, according to Joseph Sullivan, chair and CEO of investment management firm Legg Mason, as reported by The Wall Street Journal. “Just for the sake of comparison, at the height of the financial crisis in 2008, outflows were two-thirds of that number,” he noted.
Meanwhile, passively-managed large cap equity mutual funds and ETFs surpassed active funds in assets under management for the first time. As of Dec. 31, passive funds held $2.93 trillion, while $2.84 trillion was in active funds, per Morningstar research cited by Bloomberg. Among 4,600 U.S. equity, bond, and real estate funds with $12.8 trillion of assets, Morningstar found that only 24% beat their passive rivals during the 10-year period that ended on Dec. 31.
3 Danger Signals for Active Managers
- Record $313 billion withdrawn from active U.S. mutual funds in 4Q 2018
- Passive big cap stocks funds now have more assets than active funds
- Only 24% of active funds beat passive rivals over the last 10 years
Sources: Legg Mason, Morningstar, The Wall Street Journal, Bloomberg
Significance for Investors
With stock market volatility up by about 50% in 2018 versus 2017, active managers theoretically had increased opportunities to outperform. However, the share of actively-managed U.S. equity mutual funds that beat passive alternatives sank from 46% in 2017 to 38% in 2018, per Morningstar.
When volatility is up, and stock price fluctuations become more pronounced, sharp stock pickers should have more chances to exploit temporary imbalances in pricing. The widespread failure of active managers to outperform the indexes in a supposedly favorable environment in 2018 added to the flood of redemptions.
Higher costs are one reason for persistent underperformance by most actively-managed funds. The table below presents average expense ratios, comparing annual fund management expenses to assets under management, for several categories of funds, per the Investment Company Institute (ICI).
The Cost Advantage of Passive Investing
(Average Asset-Weighted Expense Ratios For 2017)
- Actively-managed equity mutual funds: 78 basis points (bps)
- Actively-managed bond funds: 55 bps
- Index equity mutual funds: 9 bps
- Index bond mutual funds: 7 bps
- Index equity ETFs: 21 bps
- Index bond ETFs: 18 bps
Source: 2018 Investment Company Fact Book, figures 6.7 and 6.8
From 2009 to 2017, total employment in the U.S.-based investment company industry grew from 157,000 to 178,000, or by 13%, per the ICI Fact Book (figure 2.16), while total net assets under management increased by 85% (figure 2.1). Average expense ratios have fallen over time partly as a result. In 2017, 39% of employees were in fund management, 28% in investor servicing, 24% in sales and distribution, and 10% in fund administration (figure 2.17; does not add to 100% due to rounding).
To stay competitive, some actively-managed funds are cutting their fees, which means eliminating staff. "It feels like every day there's another firm talking about laying people off," as Amanda Walters, a senior consulting manager in the Casey Quirk division of Deloitte, told the Journal.
It's an old truism that not everyone can be above average. With investment managers, factor in expenses, and it's virtually a mathematical certainty that a majority will be below average, compared to market indexes. While some active managers do beat the market on a consistent basis, they are relatively few in number and their past performance is no guarantee of future results. The increased popularity of passive investment vehicles reflects this reality.