We all know that the rise of ETFs and index funds has led to some significant cost pressures for actively managed funds. The more index funds tracking a local market index are available, the lower the flows into actively managed funds. This is why small and mid-cap funds have been more insulated from the pressures of index funds than large-cap or broad market funds.
Flows to active funds and market share of passive funds
Source: Lesmeister et al. (2021)
But a study by academics from the Universities of Cologne and Cambridge looked a bit closer and found that the shape of inflows to actively managed funds changes with the rise of index funds.
Traditionally, flows into actively managed funds as a function of past performance are convex. Funds with weak or average past performance see a small trickle of inflows while funds with strong past performance receive a disproportionately large amount of money from investors. One might say that a large part of the investor community is return chasing, putting their money to work wherever past performance is best.
With the rise of index funds, however, many of these return chasers seem to have moved towards index funds. Two things can be observed. As the market share of index funds rose, the flows become less dependent on past performance and stickier overall. Furthermore, the relationship between past performance and flows into actively managed funds went from concave to linear. Yes, funds with strong past performance still garnered a bit more assets than funds with weaker performance, but overall, past performance was less dominant as a criterion to attract investors flows. In fact, it’s as if with the advent of passive funds, the sophisticated and dedicated investors stayed with their investments while the fickle and naïve investors gradually moved on to passive funds.
This tendency that with the rise of passive funds the unsophisticated and fickle money moves away while the dedicated and sophisticated investors stay with actively managed funds is also corroborated by the observation that with the rise of passive funds the probability of actively managed funds closing increases. But it’s not any old actively managed fund that closes, it is predominantly actively managed funds with weak performance that close.
PS: A note of caution. I deliberately used the terms dedicated and sophisticated investors in the text above. Not all investors who are dedicated to actively managed funds are sophisticated or able to select well-performing active funds. Some are simply too stubborn to switch to passive funds even though it would improve their performance. Similarly, not all sophisticated investors who have true skill in selecting outperforming active funds will remain invested in actively managed funds. Under the pressure of investment consultants, their boards may simply decide to give up on active management and track indices even though their investment teams could do much better.
It will be interesting to see with the relentless rise of markets due to a fed put and ever lower interest rates, is that game now over??? Easy money, market cap and momentum investing may not be the best ingredients for success for the next one to two years perhaps?
It has been very enlightening to see that most of the time index funds beat active management and have lower fees. So it must be more than naive/ timid investors that are moving into index funds---there must be a lot of thoughtful folks too....... and perhaps the flip side is also true -- that some of the investors staying with active management are naive