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Passive Funds Aren’t Popular for the Reasons You Think

October 30, 2014

It’s a neat, convincing and popular story. Passive investments are gaining on their active counterparts, because investors — institutional and individual alike — have gotten hip to a couple of salient concepts.

One is that passive vehicles cost less, and keeping costs down can enhance returns. The other is that covering the asset-allocation bases is more important to investing success than chasing performance. As investors embraced these ideas, active-fund assets fell to a 71.5% share of all fund assets in June this year, down from 79% in mid-2009, says Morningstar.

But an article on the fund rater’s website questions this narrative. It’s not that the numbers cited aren’t sound or that the concepts behind them aren’t valid contributors to the growing popularity of passive investments. It’s just that other forces may also be at work.

One is the change on the advisor landscape. Since the financial crisis, more advisors have begun “levying a percentage fee on” more assets to support a more consultative and holistic business model, according to the article. “To deliver, they had to show they were upholding their fiduciary duty, which meant building solutions from a wider array of options in a more transparent way.”

In addition, these advisors are looking to “rationalize the all-in cost of their service, which might have risen if they’d continued to use actively managed mutual funds alone.” In other words, low-cost passive funds leave room for the advisor’s take without an overall fee hike.

This “should tinge the way we look at the shift that’s taken place,” writes Morningstar. “The corollary to that is we shouldn’t necessarily jump to the conclusion that advisors’ bedrock investing principles have irreversibly changed.”

It’s also worth noting that U.S. large-cap equity is where passive funds have made the most progress — a matter of no surprise to Morningstar. “It’s tough for active managers to make a living in large-caps given how widely those names are followed, and the disappointing results largely show it,” says the report. As a result, funds in this style are “good candidates for indexing, as the cost savings can meaningfully lower the portfolio’s overall internal expense ratio.”

By Thomas Coyle
  • To read the Morningstar article cited in this story, click here.