Index Funds Continue Gaining Market Share vs. Active Management

by: IndexUniverse

By Murray Coleman

While still dominating the U.S. landscape, actively managed mutual funds continue to lose market share to indexed and exchange-traded funds.

In 2007, open-end and long-term-oriented active mutual funds controlled $7.04 trillion in assets. A search of data supplied by Financial Research Corp. showed that mutual funds run by managers trying to beat their respective benchmarks held 84% of the market at the end of last year (see charts below).

But that proved to be a low point for actively managed funds in a nearly decade-long slide. In 1999, active open-end mutual funds had almost $4.2 trillion in U.S. assets, or some 92% of the market. That share total has steadily fallen in the past nine years, marking the end of a historic bull-market run by stocks.

"It's clear that investment sentiment has turned towards more passive vehicles," said Owen Concannon, an FRC analyst and director of the firm's managed accounts and alternatives research unit.

Assets at index mutual funds as a share of the overall market have been fairly stable since the late '90s, the height of a bull-market run that was followed by the tech wreck through 2002. Index mutual funds have gained about one percentage point in market share in the past nine years to 9% heading into 2008.

The real growth has come from ETFs, which jumped from 3% of the U.S. market in 2002 to 7% by the end of last year.

"A lot of it came from product momentum," said FRC's Concannon.

He pointed out that some $143 billion in ETF sales took place in 2007 compared with about $65 billion a year earlier. "So regardless of market conditions, release of new products played a large part," said Concannon.

The steady decline in actively managed fund assets reflects both growth in returns as well as new assets. Just considering net inflow, index funds and ETFs combined to attract more new investment dollars last year than actively managed funds.

That's the first time passively managed funds garnered more than half of the industry's net inflow during a single year since FRC started collecting such data.

But the ETF market remains highly concentrated. Some $31 billion of last year's $142 billion net inflow into ETFs went to one fund. That was the original SPDRs (AMEX: SPY). "It's a very concentrated market. And the 10 biggest ETFs represent about 46% of the industry," noted Concannon.

The latest FRC estimates find that roughly half of the ETF market consists of active traders such as hedge fund managers. Another half is thought to be transacted through retail channels, largely involving advisors and other financial intermediaries. Another 10% are self-directed investors. (Industry surveys by Cerulli Associates indicate that retail investors could control 54% of all retail assets now).

But passive funds still represent a much smaller base than actively managed mutual funds. Even with that spurt in assets, ETFs as a whole held about $608 billion last year. By comparison, index mutual funds had about $757.5 billion in assets.

Taken separately, indexed and ETF investments still comprise just a fragment of the U.S. funds marketplace. But FRC analysts expect growth in both areas to keep outpacing actively managed funds for the foreseeable future. In the next five years, they're projecting that ETF assets will increase at an annual average clip of 22% to top $1.5 trillion by 2012.

During that same period, mutual funds (active and passive) should grow by about 10.5% per year to $13 trillion in five years. (FRC doesn't break out estimates between the two categories in its forecast).

"If you look at how distribution's set up at ETF sponsors, their real emphasis going forward is to sell to advisors," said Concannon. "And as the fee-based compensation model grows in the advisor world, so will adoption of ETFs."

That should provide a strong tailwind for ETFs' growing popularity. After years of domination by commission-based sales models, the overriding trend in advisement services is toward a more fee-based cost structure. As of 2007, some 54% of all advisors were fee-based and 26% did a mix of fees and commissions and 20% were just commission-based, according to the latest figures from market researcher Cerulli Associates.  

"We've seen fee-based services ramping up for several years. It makes a lot of sense that more clients and advisors will gravitate to fee-based services," said Jeff Strange, an analyst at the firm.

Since studies show 70-90% of returns come from how assets are allocated, he says financial services groups are placing less emphasis on who manages portfolios. "The real trend among advisors is to focus on asset allocation. And they're using sponsors and broker-dealers to guide them through that methodology," said Strange.

Big broker-dealers like Merrill Lynch and Morgan Stanley, for example, have economists and strategists to help guide that process. "But advisors certainly have the freedom to tweak and make allocations more individualized," added Strange.

Still, ETFs face challenges in becoming more mainstream with advisors. Managed accounts, a popular form of portfolio management for wealthier investors, still prefer stocks and other investment vehicles, says Strange. He estimates ETFs make up only around 3% of the major managed account platforms today.

"These programs tend to be packaged (i.e., the advisor cannot make changes), which is undesirable for many advisors. It is also difficult to sell passive investments as a managed account and charge an ongoing asset-based fee - particularly if the value proposition is for a client to maintain a long-term strategic allocation through ETFs," Strange wrote in a recent note.


Source: Financial Research Corp.

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