10.27.2014
By Terry Flanagan

Morningstar: Active Funds Could Make Comeback 

Jeffrey Ptak, president and chief investment officer of Morningstar Investment Services, said there is evidence that investors have not totally lost their faith in active management despite increased flows into passive funds.

In the latest Morningstar magazine Ptak said active funds were 79% of fund assets in June 2009 but fell to 71.5% in the next five years due to the rise of passive funds.

He wrote: “The data doesn’t unequivocally support the notion that investors have gotten religion about costs or totally lost their faith in active investing. In fact, when we burrow into the data, we find a number of trends that raise questions about, if not contradict, those assertions.”

American Funds, a large actively managed fund complex, was a disproportionate part of the fall in market share for active funds as its funds faltered during the financial crisis and financial advisors changed their business models to build lower cost portfolios according to Ptak.

However Ptak wrote: “We shouldn’t necessarily jump to the conclusion that advisors’ bedrock investing principles have irreversibly changed – that they’ve been reborn as indexing zealots and won’t ever go back.”

Passive funds made most inroads in large-cap equity with their share of assets rising from 8.5% to nearly 12% in the five-year period ended July as more than 80% of active large-blend funds lagged the Vanguard Total Stock Market Index over the trailing decade ended July 31.

“Domestic large caps typically comprise a large share of the typical US investor’s equity allocation,” added Ptak. “Thus, they’re good candidates for indexing, as the cost savings can meaningfully lower the portfolio’s overall internal expense ratio.”

In contrast actively managed foreign large-cap funds gathered $97bn in net new inflows over the five-year period ended July despite not performing well and the potential for greater cost savings in passive funds.

“It’s likely that some investors continue to view foreign stocks as an area that’s more hospitable to active investing and, therefore, worth paying up for (despite evidence seemingly to the contrary), added Ptak. “But looking beyond that, it’s also quite possible that foreign active funds don’t carry the same stigma as active US large-cap funds, which were badly oversold to investors during the tech run-up, only to leave them feeling burned when the bubble burst and the financial crisis followed.”

Investors are also still willing to pay high fees for alternative mutual funds which gathered $152bn in net inflows over the five-year period ended July. Ptak said that as of July, the typical alternative fund charged 1.72% in annual expenses, more than 10 times the cost of Vanguard Total Stock Market Index Fund.

“With respect to alternatives, this at least partly reflects the new paradigm of pairing ultra-low-cost “beta sources” like broad-market index funds with supposed “alpha-generators” like alternative funds,” said Ptak.

Investors were also more prepared to pay for active management in taxable bond funds which gathered $743bn in net inflows over the five-year period ended July.

Ptak said that reviewing the data shows that some investors have gone passive for complex reasons, which raises questions about how committed they really are to low-cost investing.

“Taken together, it’s a picture of investors trying to sort through a jumble of different emotions and circumstances, sometimes without the resolve or consistency that the “active is dead, passive forever” narrative would lead one to believe,” he added. “There’s still plenty of work to be done, and the flight to passive shouldn’t lead us to conclude otherwise.”

Featured image via iStock

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