Equities: The shift from active to passive

By Felix Salmon
August 31, 2010
Sam Mamudi has found a new way to slice mutual-fund data, and the results are very interesting: the flows aren't just from domestic funds to international funds, as we can see from the monthly ICI data, but also from actively-managed mutual funds to index funds.

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Sam Mamudi has found a new way to slice mutual-fund data, and the results are very interesting: the flows aren’t just from domestic funds to international funds, as we can see from the monthly ICI data, but also from actively-managed mutual funds to index funds.

Since the end of 2005, actively run U.S. stock funds have seen net outflows every year, totaling $369 billion, while indexed counterparts — not including exchange-traded funds — have seen net inflows of $112 billion, according to fund-industry trade group the Investment Company Institute.

I went one further, and had a look at the ICI’s data on ETF flows. After all, to a first approximation, all ETFs are index funds rather than actively-managed.

Here’s how the numbers break down: total actively-managed mutual funds, both domestic and international, saw a net outflow of $37.7 billion in 2009, and of $24.1 billion in the first seven months of 2010. Meanwhile, passively-managed index funds saw a net inflow of $22.9 billion in 2009, and of $22.4 billion in 2010 so far. But get this: equity ETFs saw net inflows of $69.3 billion in 2009, and another $21.4 billion in 2010 to date.

Those numbers aren’t publicized by the ICI: I had to calculate them using their spreadsheet of monthly ETF data. But if you add it all together, there was a net inflow into equities of $60.5 billion in 2009, and another net inflow of $19.8 billion in the first seven months of 2010. People aren’t pulling their money out of the stock market, they’re just pulling their money out of actively-manged mutual funds in general, and actively-managed domestic mutual funds in particular.

If you look at growth rates, the numbers are even starker. Actively-managed domestic mutual funds saw an outflow of $44 billion in the first seven months of 2010, which was 1.45% of their total value. Equity ETFs, by contrast, saw an inflow of $21.4 billion, which was 3.12% of their total value. If you go back to 2009, the numbers are -2.07% and +10.78%, respectively. Yes, in 2009, the net inflow into equity ETFs (I’m not even including bond or commodity ETFs, here) was greater than 10% of their entire year-end value. Mutual funds, it’s fair to say, never see those kind of net inflows.

This shift is only just beginning. There’s more than $3 trillion invested in actively-managed domestic mutual funds, compared to just over $1 trillion in domestic index funds and domestic equity ETFs combined. On the international side, there’s $1.2 trillion in actively-managed mutual funds, compared to $218 billion in international ETFs, and just $97 billion in international indexed mutual funds.

So in terms of long-term investments, people are still massively overweight actively-managed strategies. But they’re sensibly rotating out of those funds, and into passive ETFs. As that trend continues, and I see no indication of it slowing down at all, one can only expect that correlations between different stocks will continue to rise. And as correlations rise, of course, it becomes increasingly difficult to justify an active strategy.

ICI chief economist Brian Reid says that “considering historical investor patterns for the last 20 years, we are currently seeing weaker investor demand for domestic equity mutual funds than those patterns would lead us to expect.” Too right we are. And there ain’t gonna be no mean-reversion, either. That $3 trillion is going to end up reallocated, sooner or later. And if your business model is based on managing domestic mutual funds and getting a steady flow of new investments, you’re not going to find life easy going forwards.

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