Cost considerations and the failure of active managers to deliver the outperformance they promise are the main factors driving this shift. The performance of active funds in 2022 certainly disappointed – the market volatility that characterised the year should have provided an ideal environment for them to excel.
‘Those active managers that were not able to perform in the down market of 2022 will most likely see their assets go to passive strategies, or to other active managers that performed well in this difficult environment’, says Scott Treacy, research consultant at Investment Metrics2.
Poor performance
Morningstar found that, of the nearly 3000 active US funds it analysed, only 43% survived and outperformed their average passive peer in 2022. The results varied widely across asset classes and categories. US stock-pickers outperformed their average passive peer 49% of the time in 2022, while only 34% of active foreign funds did so. In all cases, however, investors in active funds had a less than even chance of choosing a fund that outperformed3.
The results were even worse in fixed income: just 30% of active US bond funds beat their average index peer last year. Managers in corporate bonds fared particularly poorly, with just 23% outperforming, reports Morningstar4.
Looked at over a longer horizon, the results are even worse for active managers. Only one out of every four active funds topped the average of their passive rivals over the ten-year period ending in December 2022, says Morningstar.
Bearing the cost
Costs have a significant impact on performance. Morningstar’s review of US funds’ performance found that the cheapest funds succeeded more than twice as often as the priciest ones (36% success rate versus 16%) over the ten-year period to 2022.
Vanguard, which has a significant passive business but has also long been an active manager, explains how management fees eat into investor returns:
‘Investment costs might not seem like a big deal, but they add up, compounding long with your investment returns. In other words, you don’t just lose the tiny amount of fees you pay—you also lose all the growth that money might have had for years into the future.’
Vanguard cites the example of $100,000 invested in a fund that returned 6% each year over 25 years. If the fund had no costs or fees, the investor would earn around $430,000. Add in 2% annual costs, and the return falls to $260,000. So, the 2% annual charge would wipe out almost 40% of the final account value.
The shift to passive strategies is certainly pressuring managers of active funds to cut fees. Post-negotiated fees fell for US active managers in most categories in 2022, including emerging-market equity, US fixed income, and non-US large growth and value equity, according to data from Investment Metrics.
American fixed-income managers, who experienced an average decline of 7% year-on-year (YoY), saw the largest drop in fees. US large growth and value equity managers saw a slight increase of 1% in fees, equivalent to a significant cut in real terms, given that inflation averaged 8% 5, 6.
The trend towards passive may well be irreversible. Active managers simply cannot generate enough alpha to justify the higher fees over passive and exchange-traded funds (ETFs). In response, active firms are responding by trying to diversify their businesses, adding higher-margin products such as private assets or targeting new client types or geographic regions, sometimes through acquisitions. Many are also launching ETF versions of their active products.
Entering the doom loop?
Falling fee income threatens to undermine the ability of active fund managers to invest in new technology and attract top talent. The outlook appears to be one of continuous decline as investors migrate to passive options. Alternative investments, such as private equity, provide a bright spot, but even here, trends such as tokenisation constitute a threat to income.
1 https://www.bloomberg.com/news/articles/2023-02-21/global-passive-equity-funds-set-to-take-asset-crown-from-active
2 https://www.institutionalinvestor.com/article/b8xr09bwk9fdq2/As-Active-Funds-Struggle-to-Outperform-Fee-Declines-Get-Worse
3 https://www.morningstar.com/articles/1140588/active-funds-continue-to-fall-short-of-their-passive-peers
4 https://www.morningstar.com/articles/1140588/active-funds-continue-to-fall-short-of-their-passive-peers
5 https://www.institutionalinvestor.com/article/b8xr09bwk9fdq2/As-Active-Funds-Struggle-to-Outperform-Fee-Declines-Get-Worse
6 https://www.usinflationcalculator.com/inflation/current-inflation-rates/#:~:text=To%20find%20annual%20inflation%20rates,average%20inflation%20rate%20was%208.0%25
