Flows into passive products to gather steam, says Moody's

Flows into passive products to gather steam, says Moody's

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Outflows globally from traditional actively managed mutual funds into lower-fee passive investment products will continue to gather steam, according to experts at Moody's.

"Passive investments constitute roughly one-third of the US mutual fund market today, and we expect this share to expand well above current levels over next five years," says Stephen Tu, a vice president and senior analyst at the ratings agency.

"Looking ahead, absolute performance will be a more important consideration for investors than relative performance, given that the majority of active managers underperform their benchmarks."

Active managers try to pick attractive stocks, bonds, mutual funds and time when to move into or out of markets or market sectors.

They also place leveraged bets on the future direction of securities and markets with options, futures, and other derivatives. 

But the deteriorating ability of money managers to beat their indices has led to investors accelerating a shift towards passive strategies, which in invest in broad sectors of the market, called asset classes or indexes.

Like active investors, passive funds are designed to make a profit, but accept the average returns various asset classes produce.

Vanguard, BlackRock and State Street Global Advisors have all benefited from the trend.

Others, including Legg Mason, Janus Capital Group and Fidelity have recently altered their strategies, and either made acquisitions or created new products to address the shift 

Moody's considers overcapacity in active management to be a primary cause of investment underperformance. 

Moreover, active funds' high fees are also more noticeable and impactful to investors in the present low-yield environment, accelerating the shift toward passive investments.

Meanwhile, regulators around the world have pushed for greater transparency on costs and more disclosure on fees and potential conflicts of interests.

In the US, the Department of Labor's new fiduciary rule is likely to accelerate the shift to passive, and cause sales behaviour to change.

"Under the new regulation, advisors are expected to ensure investments are in the best interests of their clients, rather than merely suitable for them. In practice, it will become more difficult for advisors to place their clients into higher-cost and more complex investment products,” said Tu.

“Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interests and minimize fiduciary risk", he added.

"In addition, the legal risks are highly significant in the new regulatory regime and will impose a higher bar on new sales of more expensive actively managed funds to retail investors."

Although some financial fundamentals remain robust for asset managers - with industry-wide financial leverage still moderate - earnings have weakened owing to the persistent, and now accelerating, flow of assets into passive investment products, and out of traditional mutual funds. 

According to Moody's, active management will likely have to shrink substantially over time in an attempt to improve performance.



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