Market Extra: Passive investing, a winner in 2016, shows no sign of stopping

2016 was the year of the passive investor—again.

One of the biggest investment trends of the past decade continued unabated this past year, as investors rotated out of active investments—where the components are chosen by an individual or team rather than being pegged to a benchmark—to passive-based ones.

According to Morningstar, active funds saw outflows of $285.2 billion in 2016; passive funds attracted inflows of $428.7 billion. This extends a trend that has occurred for nearly 10 years, according to EPFR Global.

While more assets continue to be held in active strategies than passive—$9.3 trillion versus $5.3 trillion, according to Morningstar—the shift is clear, and the reasons behind it are simple: Not only are passive-based strategies typically cheaper than active ones (analysts see the industry in a “race to zero” when it comes to fees), they’ve historically boasted greater performance.

Winning may be hard to measure. Passive strategies, by definition, cannot outperform (or underperform) their underlying index. And, the number of active strategies that can consistently “beat the market” over the long term is essentially zero. According to S&P Dow Jones Indices, a mere 0.81% of large-cap domestic equity funds remained in the top quartile of performers over five consecutive 12-month periods. Results were even worse for other market cap and asset class categories.

These issues—performance and fees—have also led to an exodus from hedge funds and their Exchange-traded fund imitators in 2016.

Passive strategies particularly pay off in bull markets, when gains are fairly broad-based. In order for an active equity fund to outperform this year, it would have had to surpass the S&P 500’s SPX, -0.46%  11.1% rise, and do so by such an extent that the gains were larger than the broader market’s return even after fees were taken into account.

That outcome is so hard to achieve that in a relatively strong period for active managers—the third quarter of 2016, when markets were extremely volatile due to the fallout from Brexit and the U.S. election—only 53% of active managers managed the feat.

Opinion: This might be the time to turn away from index funds

A number of active managers fail to outperform because they have low degrees of “active share,” meaning they have a high overlap with their underlying benchmark. This limits the funds’ potential for outperformance, especially after fees are taken into account.

According to Andrew Slimmon, a managing director at Morgan Stanley Investment Management, it is extremely difficult for an active manager to outperform net of fees if their active share is below 80%. Arguably, only one well-known entity has managed the feat: the Dow Jones Industrial Average DJIA, -0.29% which is chosen by committee and has outperformed the S&P 500 for large stretches of time.

The move into passive is not only seen continuing in 2017, it is expected to accelerate, when the Labor Department’s “fiduciary rule” takes effect in April. The rule requires that the financial advisers and brokers who handle individual retirement and 401(k) accounts must act in the best interest of their clients, rather than recommending investments that, although clients may be able to afford them, may not be the cheapest or best options.

Advisers are more likely to recommend passive to a far greater extent than active or “smart beta” funds, which use rules designed to deliver a particular investing strategy like “low volatility” or “momentum.” These funds have higher fees than passive strategies, and research has shown that they don’t boast notable or consistent outperformance over passive strategies.

In May, Morningstar estimated that “upwards of $1 trillion may move into passive investments” as a result of the rule. By another estimate, the market for exchange-traded funds—more tax-efficient than mutual funds and heavily tilted toward passive strategies—could triple to $10 trillion by 2020.

Advisers to President-elect Donald Trump have said that he would repeal the rule, but most industry watchers think that step is unlikely. Even so, such action isn’t expected to halt the trend toward passive investing.

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