Tracing the trajectory of the fund arms race

Data suggests advisors had a hand in the way capital flows have favoured index funds and ETFs

Tracing the trajectory of the fund arms race

Much of the narrative surrounding the rise of index funds and ETFs in recent years has centred on their appeal to the cost-conscious investor and passive funds’ outperformance over their active counterparts. But from the perspective of Andrew Guillette, Senior Director, America Distribution Insights at Broadridge Financial Solutions, advisors play a significant role as they balanced business and portfolio-management considerations.

His view is informed by the U.S. experience, where index funds were first considered more as an esoteric curiosity than a disruptive innovation. “In terms of a brief history, most of the US investment-fund marketplace was born with active,” he said. “When index funds were first introduced, commission-based advisors weren’t able to sell these no-load products, although this wasn’t the case with the registered investment advisor channel.”

Index funds appealed heavily to fee-based financial advisors, who were better able to justify their own compensation when they used index funds in their clients’ portfolios. That worked out very well for the RIA channel, and their success wasn’t lost on large brokerage firms. In response, they introduced fee-based managed account programs. Those programs came with pricing arrangements into which index funds could be “tucked in,” as Guillette put it.

“Then ETFs were introduced as the most recent product type,” he said. “They really have taken the industry by storm.”

The dramatic swing away from actives is evident from fund flows through the U.S. intermediary-sold channel over the past three and a half years. Including 2016 up to the second quarter of this year, Guillette said that active funds have seen outflows of US$486 billion; index mutual funds, meanwhile, have seen US$277 billion in inflows, while ETFs collected US$845 billion.

“As you think about an advisor, structuring a portfolio, they're obviously very focused on cost for their clients,” he said, noting how costs of an underlying investment can hurt both the client’s return and an advisor’s overall compensation. “It makes sense to put low-cost performers in there.”

There’s definitely a zero-sum game afoot, with active mutual funds turning out as the biggest losers. As investors and advisors abandon actively management mutual funds, particularly those that are high-cost yet lower-performing, they are reinvesting their dollars into index funds, primarily equity ETFs.

And there’s the rub: looking at the different asset-class exposures of investment funds reveals a bright spot for active managers in fixed income. By re-examining U.S. intermediary-sold fund flows over the past three and a half years through an asset-class lens, Guillette found that equity strategies lost US$536 billion.

“Fixed income tells a different story; it gained US$206 billion,” he said. “Frankly, they account for all of the positive cash flow that active funds saw over the last several years overall.”

The bond market’s place as a bellwether for active managers is understandable considering its sheer depth and breadth. With a deeper pool of capital and far less efficiency, the search for alpha and yield that can beat the market — especially desirable in a world of low-to-negative interest rates — has the potential to be more fruitful.

Ramped-up product innovation has also taken investment funds beyond simple dichotomies. Smart-beta funds, with roots going as far back as the 1960s, have gained more attention as asset managers attempt to straddle active management and simple passive investment; based on information from Lipper funds, Guillette said there are around US$1.05 trillion in assets in smart-beta products.

“But if we look at Smart-beta product development in the U.S., our records show it started with 600 launches in 2015, and it’s dropped down significantly each year,” he said. “Year-to-date, we see only three new Smart-beta funds introduced in 2019, so you have to ask whether the market is saturated.”

Investors also now have the choice to purchase multi-asset products, which offer single-ticket access to blends of stocks and bonds. Still, the popular preference appears to lean toward more focused products, as asset-allocation products have suffered 15 consecutive quarters of outflows based on Broadridge data.

“It would seem like they're out of favour, especially with the push toward model portfolios,” Guillette said.

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