Persistent underperformance of traditional active management and new regulations are likely to accelerate global net outflows from traditional actively managed mutual funds into lower-fee passive investment strategies, said a report released Monday by Moody's Investors Service.
"Passive investments constitute roughly one-third of the U.S. mutual fund market today, and we expect this share to expand well above current levels over the next five years," said Stephen Tu, a vice president and senior analyst at Moody's, in a news release accompanying the report.
Mr. Tu added: "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."
Moody's considers overcapacity in active management to be a primary cause of investment underperformance. According to various studies, traditional active management has consistently underperformed in all varieties of market conditions.
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, the report said.
Meanwhile, global regulators have pushed for greater transparency on costs and more disclosure on fees and potential conflicts of interests. In the U.S., the Department of Labor's new fiduciary rule is likely to accelerate the shift to passive and cause sales behavior to change, Moody's said.
Although some financial fundamentals remain strong for asset managers — with industry-wide financial leverage still moderate — earnings have weakened as more assets flow into passive investment offerings. Active management will likely have to shrink substantially over time in an attempt to improve performance, the report said.
Managers that specialize in passive investing, such as Vanguard Group, BlackRock and State Street Global Advisors, are benefiting from the current trend. The scale and liquidity advantage that these firms have with core index strategies — together, they have roughly 70% of market share in global exchange-traded fund assets — have created a strong barrier to entry for other firms.
Some traditional active managers are attempting to adjust their business models in response. A number of active managers that had not previously offered passive strategies have recently altered their strategies, and either made acquisitions or created new strategies to address the shift from active to passive investing. Among this group are Franklin Resources, Legg Mason, Janus Capital Group and Fidelity Investments.
Many active managers view mergers and acquisitions as a strategy to address the passive trend. However, Moody's is skeptical, particularly given that in most cases acquisitions don't address the root cause of active underperformance since they don't reduce the amount of capital run by active managers.
Instead, Moody's anticipates a gradual repositioning of the traditional active mutual fund industry as a whole, including a re-emphasis on investment performance over growth and marketing, and more discipline in curtailing fund sizes and management costs.