There is little argument that Exchange Traded Funds, more commonly referred to as “ETF’s” have and will continue to change the landscape of investing. As my colleague Cullen Roche penned:

“The rise of low-cost indexing is one of the most transformational trends in modern investing…The rise of low-cost diversified index funds has changed the meaning of an important debate in finance – the active vs passive debate.

Currently, the debate over “Active vs. Passive” is raging as article after article is penned discussing the money flows into ETF’s.

For example, the Wall Street Journal published an article entitled “The Dying Business of Picking Stocks” stating:

Over the three years ended Aug. 31, investors added nearly $1.3 trillion to passive mutual funds and their brethren—passive exchange-traded funds—while draining more than a quarter trillion from active funds, according to Morningstar Inc.”

CNBC also jumped on the bandwagon with “Peak Passive? Money Is Gushing Out Of Actively Managed Funds.” To wit:

“Investors bailed on actively managed funds in record numbers during 2016, preferring the reliability and low costs of index funds over taking a chance on finding a stock picker who could beat the market.”

It would certainly seem to be the case given the flow of funds over the last couple of years in particular as noted by ICI and shown in the chart below.

The exodus from actively managed mutual funds is occurring for four primary reasons.

  1. Expenses: The management fees on passive funds are extremely low as the funds do not require investment analysis. In fact, an excel spreadsheet with a few lines of macro coding can replace a traditional portfolio manager. The WSJ article found that fees are almost eight times higher for active funds than passive ones (.77% vs. .10%).
  2. Relative Performance: Not surprisingly, in a market that has been fueled by massive Central Bank interventions, passive funds have outperformed actively managed funds. In the aforementioned article, the WSJ found that over the last five years a meager 11.2% of U.S. large-company mutual funds (actively managed) outperformed the Vanguard 500 passive index fund. Of course, this is due to expense difference as noted above.
  3. Technology Shifts: The advancement for algorithmic and computerized trading is leading to a migration of assets into ETF’s which are ideal for computer-driven allocation models.
  4. Media: One of the biggest reasons for the flows from actively managed mutual funds into ETF’s has been the increased press and media attention on ETF’s. As the markets have pushed higher, and the performance and expense differential exposed, the media has berated investors for not being invested regardless of the risk. Therefore, investors have been “psychologically pushed” to buy ETF’s as the “fear of missing out” has accelerated.