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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“And as correlations rise, of course, it becomes increasingly difficult to justify an active strategy.” I’m not sure that’s right. If you’re looking at correlations of daily returns, don’t forget that they’re noise for long-term investors. As more money in the stock market becomes dumb, there are more rewards for smart money. (Of course, there aren’t any rewards for money that thinks it smart, but isn’t).

Posted by SimonMorris | Report as abusive

I wonder how much of the ‘passive’ money comes from retirement funds– particularly now that new money in defined contribution plans will generally default to ‘balanced’ funds that invest in varying percentages of bonds and equity index funds.

Posted by MattF | Report as abusive

I think that the more money is in these passive index funds the more volatility we’re gonna see. It’s supply and demand: the supply will be diminished sinced it’s now tied up in more and more passive funds, so any demand spikes will lead to greater variance. And I’m sure that suits day-traders and people that add little value to the economy just fine, but it scares off real investment in the real economy.

Posted by CDN_finance | Report as abusive

You could also read the figures differently: fewer retail and more institutional investors.

Posted by FifthDecade | Report as abusive

Good work and good post, Felix!

Posted by DanHess | Report as abusive

Unintuitively, the market could actually get ‘smarter’ if it gets more passive. Why? Because the indexed money mimics the cummulative decisions of the active money, and the active money is seeing a ‘selection’ process.

If many mediocre money managers leave or endure forced shrinkage, the active managers that remain will be much more elite and talented. There is a subset of active managers, mostly at hedge funds, who really can beat the market reliably.

Posted by DanHess | Report as abusive

@DanHess, I think you assume too great a sense of discernment amongst investors. Retail investors go with what they are sold, usually from their banks, and that usually isn’t what performs best long term; and it’s been said that 80% of professional investors follow what the market is doing anyway. I don’t believe Hedge Funds are any better here either. Humans are humans and boys will be boys, and when their testosterone gets up they still overbuy or oversell depending on whether they are on a run or not.

Posted by FifthDecade | Report as abusive

I suspect there are a small number of professionals who have the insight and discernment to consistently beat the market, however their rewards are far greater working at an investment desk or hedge fund than running a mutual fund. This is especially true because mutual fund investors punish a fund that underperforms its peers far more than they reward one that overperforms. The safest and most lucrative path is to simply track the market with 90% of the portfolio and play small games with the remaining 10%.

The move to ETFs may partly stem from a disillusionment with mediocre money managers, but it also permits active investors greater control in managing their money. If they issue a sell at 10:00 it gets executed at 10:01, instead of six hours (and 600 points drop) later. Finally, the fee structure and freedom from account minimums are attractive.

Posted by TFF | Report as abusive

Helpful post Felix – thanks. Does anyone have tips on how to get cheap passive equity exposure in the UK? We don’t yet have free online brokerage accounts (ii comes close) and TERs for basic FTSE products look outrageous compared to the US, and even more so for bond or foreign ETFs.

Posted by Jamie799 | Report as abusive

With no disrespect, when you say, “just $97 billion in international indexed mutual funds.” you woefully understate the amount that’s passively invested in non-US mutual funds.

Dimensional Fund Advisors, a global provider of passive mutual funds, alone, has over $70 billion invested in mutual funds, as opposes to ETFs, in non-US developed & emerging markets, all passively.

Posted by HowardRoarke | Report as abusive

Howard, do you have a source for that?

Posted by FelixSalmon | Report as abusive

Mr. Salmon,

The overall AUM at Dimensional as of June 30, 2010 was over $160 billion. This can be verified at its public website: http://www.dfaus.com

All of the equities included in that amount are invested in a passive manner.

Dimensional is an institutional-only investment firm and did not break out the amount of the overall number above that was invested in non-US assets on its public access website (i.e., the $97 billion). However, you should be able to verify it by contacting Dimensional.

However, I do need to make one correction in my earlier post. While none of Dimensional’s offerings are ETFs, it does provide its investments in vehicles other than “mutual funds.” For example, I believe it offers collective trusts and mutual-fund-like-vehicles in other countries. The main point I was trying to make was that none of these investments are structured as ETFs.

Posted by HowardRoarke | Report as abusive