Passive investments could make up half of all U.S. equity retail flows in 2018 and 2019, estimates Credit Suisse’s Craig Siegenthaler, but that’s not because investors love passive so much as they hate fees.
In a new note, Siegenthaler writes that a focus on fees is the main driver in the rotation from active to passive, especially as active manager have to outperform more to make their strategies breakeven for clients paying higher costs. The trend is providing large inflows to the two biggest passive ETF managers, Vanguard and BlackRock’s (BLK) iShares, although there’s “aggressive” price competition for their core, cap-weighted segments.
He argues that this calendar year will see the largest dollar shift in assets under management from active to passive, with the money flow declining a bit next year. There are a number of factors behind this, including the original April 2017 deadline for the US DOL’s Fiduciary Standard Rule, which led brokers to revamp their business models and subsequently pressured commission-based accounts and spurred growth in fee-based accounts that have higher passive share.
He also writes that, in part due to fear of future lawsuits, he thinks that fees have come more into focus in the broker and consumer selection process.
More from his note:
Institutional investors generally invest in passive strategies through separately managed accounts, but may also invest through the ETF structure. Retail investors tend to invest through the ETF structure or mutual funds. Vanguard’s founder Jack Boggle actually prefers for investors to use the mutual fund vehicle, as he thinks the mutual fund structure encourages a longer-term holding period than ETFs, and also we note that mutual funds don’t exhibit the flash crash risk that are inherent with ETFs. We think retail investors are coming to the conclusion that it’s hard to find managers that can consistently beat the benchmarks after fees, so more and more investors are deciding to go passive. We estimate the total equity passive / active mix is now 45/55% among US institutional investors, while it’s lower in retail at 35/65%. According to P&I, 54% of all US equity investments are now passive for the 200 largest DB plans. We believe these levels will continue to increase, especially in asset classes where active has exhibited poor performance versus passive. This includes asset categories that have high dispersion (low correlations) between securities and funds.
We continue to expect traditional AuM to shift to passive in the US, and while the speed may slow in 2018/19, we expect to see a pick-up in the active-to-passive shift in non-US markets like the UK and continental Europe.
The Financial Select Sector SPDR (XLF) is up just under 7% this year.