Ruth Saldanha: The U.S. active equity mutual fund industry has dramatically changed in 30 years. In 1991, active mutual funds were about 97% of the total U.S. fund market but then dropped to 46% by 2021. A new research from Morningstar's James Xiong, Tom Idzorek and Yale's Roger Ibbotson predicts that if current outflows continue, then by 2036, the AUM of active mutual funds will drop to below 20%. But why? And what will the impact of these outflows be on the active mutual fund industry? James Xiong, one of the authors of the report and Morningstar Investment Managment's Head of Scientific Investment Management Research, is here today to talk about the report and some of its findings. James, thank you so much for being here today.
James Xiong: Thank you for having me.
Why Are Flows Moving Out of Active Mutual Funds, Into Passive Funds?
Saldanha: So, let's start by talking about the Great Migration. What are some of the reasons for these outflows from active to passive funds? And will these reasons persist going ahead?
Xiong: First, I would like to make it clear that our research focuses on U.S. equity active mutual funds, which is just one type of active management. To me, the most obvious reason for this great migration from active mutual funds to passive funds is higher fees charged by active funds, which is about 70 basis points higher than passive funds. So, it is very well known that active funds in aggregate is close to be a zero-sum game minus costs. So, the net return to an average active fund will be 70 basis points lower than an average passive fund. In the long run, this 70-basis-point is going to make a huge difference. So, it is not surprising that this will lead to the Great Migration. In addition to this, our research identified another reason which is the impact of flows on performance. We found that positive flows lift performance, but negative flows drag down performance. When performance is dragged down, it accelerates the migration. These two reasons will likely persist in the future because number one, active funds cannot lower the fees by too much further and the outflow has been formed like a strong trend, which is very hard to stop.
Expect Active Mutual Fund Share in the U.S. to Drop to 17%
Saldanha: So, walk us through what happens to active mutual fund AUM share if these outflows continue over the next decade-and-a-half or so.
Xiong: The active mutual fund AUM share is defined as the ratio of the total active mutual funds AUM over the total active plus passive fund AUM. So, the passive funds include index funds and ETFs. The active fund AUM share was 97% back in 1991. So, it dominates passive. It was 46% in 2021 when we wrote the paper. So, even if we assume the same outflows of the last 15 years continue over the next 15 years, the active share will drop to 17%, that's below 20%, by 2036. The latest active share at the end of 2023 that's just a couple months ago has already dropped to 39%, very close to our forecasted 41% in our paper.
Mutual Fund Outflows Mean Worse Fund Performance
Saldanha: But have these outflows impacted active mutual fund performance? How? And by contrast, how have passive funds performed in the period that you examined?
Xiong: So, the performance for passive funds is relatively stable over the time as they have consistently attracted the inflows over the last 30 years. However, active funds experienced a sharp transition. They had net inflows before 2006, but they have net outflows afterwards. The cumulative outflows are about $2.2 trillion since 2006. We estimate that the flow impact on annualized alpha for aggregated active funds industry was a positive 33 basis point between 1991 to 2005, but it was a negative 10 basis point between 2006 and 2021. The inflows from 1991 to 2005 act as a tailwind, but the outflows from 2006 to 2021 act as a headwind on the performance. This headwind can create a vicious circle for the active fund industry. Active funds have a bad net return due to higher fees. This can lead to bad net returns, while this bad returns lead to outflows. These outflows lead to additional negative performance due to the flow impact, which will lead to additional more outflows. So, this is like a vicious circle for active fund industry.
Active Mutual Funds Performance is Getting Steadily Worse in Times of Crisis
Saldanha: Let's talk about that some more. Based on net returns active mutual funds underperformed index funds in most cases. But active funds outperformed index funds during the internet bubble bust and the Global Financial Crisis and then underperformed during the COVID crisis. So why is that?
Xiong: Some academic studies reported evidence that active funds perform better and added more value during crisis periods prior to 2006. And this could be a good argument that active funds deserve higher fees because they can mitigate the downside risk. Unfortunately, this outperformance during crisis period has declined or nearly disappeared after 2006. Our analysis clearly shows that the performance of active funds in crisis period has declined over time. From big outperformance during the internet bubble bust to small outperformance during Global Financial Crisis and finally to big underperformance during COVID crisis. There could be many reasons for this, but we have found one of them that is as fund flows change from inflows to outflows, the performance can change from outperformance to underperformance. This applies to not only normal periods but also crisis periods.
Does the Movement of Funds Into Passives Mean the Market Is Getting Less Efficient?
Saldanha: So, finally, let me ask this. As the share of active mutual funds reduces relative to passive funds, is it possible that the market may become less efficient thereby creating opportunities for active managers to generate alpha and outperform and then increase flows to these funds? And then what happens to the idea that fund share of active mutual funds might actually drop below 20%?
Xiong: This is a very interesting question. Our paper didn't address this question directly, but I can share some of my thoughts. Some research has found that more passive investing or less active investing can reduce information production. That's very easy to understand because less demanding from the gathering information will lead to less information production. Now more index trading such as ETFs can increase core movements and correlation among stocks. But it can also increase stock volatility. However, there is no clear consensus on whether more passive investing or less active investing will impact market price or price efficiency. Some suggested that it doesn't change price efficiency, but some people argued as you ask that market may become less efficient because of less active investing which can create opportunities for active managers to outperform and therefore attract inflows back into this active funds. It is very difficult to test the price efficiency, but it will be very easy to find out if money flows back into active funds after 5 or 10 years. So far money is still flowing out from active funds. When the active share drops below 20%, I believe regulators will be more concerned and arbitrages or hedge funds may play more roles.
Saldanha: Thanks so much for being here today, James.
Xiong: Thank you, Ruth. It's my pleasure.
Saldanha: For Morningstar, I'm Ruth Saldanha.
