Gallery:Step 7|Step 7: Silent Partners

Actively Managed Funds Continue to Lose Market Share

Gallery:Step 7|Step 7: Silent Partners

Recently, when I was browsing the Morningstar Website, I stumbled upon a video titled “What’s Driving Investors Away From Actively Managed Funds?” In the interview with Christine Benz, Morningstar’s editorial director Kevin McDevitt states:

“If you go back three years, the actively managed equity funds had about 73% market share among all U.S. stock funds; that has fallen from 73% to about 67% today, and about a third of the market share has gone to passively managed funds, both open-end index funds and also ETFs... In terms of why that's happening: I think there has been a real disillusionment with actively managed funds, and I think part of that certainly is performance related…And I think actively managed funds are still quite expensive in many cases relative to passive funds, and ETFs certainly. So there is also a cost component to this, too.”

Knowing that so many people use Morningstar for the purpose of picking active managers, I found this statement to be refreshingly honest.

A bedrock principle of free-market economics is that capital should ultimately flow to its highest and best use. If the costs paid for active management do not produce higher returns for investors, then capital should flow to a better use. Eugene Fama, the father of modern finance, was recently asked by Client Insights host Dan Richards if active managers earn their fees. Fama explained the key finding of the paper “Luck vs. Skill in Mutual Fund Performance” that he published with Ken French in 2010:1

“Looking at funds over their entire lifetimes, only 3% demonstrate skill after accounting for their fees, and that's what you would expect purely based on chance. Even the active funds that have generated extraordinary returns are unlikely to do better than a low-cost passive fund in the future.”2

At Index Funds Advisors, Inc., we have reported on this study and many others which conclude that paying an active manager to beat the market is most definitely not an optimal deployment of capital, to put it in the kindest terms possible. We see no reason for the long-term trend of capital moving from active to passive to abate. As for the timeworn argument that if everybody goes passive, the financial markets will implode, we are still a very long way from that being a concern.

 


1 Fama, E. F. and French, K. R. (2010), “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” The Journal of Finance, 65: 1915–1947.

2 http://www.dimensional.com/famafrench/2012/06/fama-do-active-managers-earn-their-fees.html