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Active vs Passive: A Sudden Shift in Investors’ Preferences?

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If you only read the headlines for Morningstar’s latest Direct Fund Flows Commentary, you might walk away with the impression that investors who fled from funds in December 2018 have come back in force. And that the dominance of passive funds over active funds is finally beginning to crack. Now that happy days are here again, maybe it’s finally time for your boutique asset management firm to roll out its new funds and kick sales and marketing into high gear.

Then again, you might want to temper your optimism. Because if go behind the headlines of the Morningstar report, you’ll see that the numbers aren’t as impressive as they might seem when taken out of context.

Headwinds or Hype?

Let’s examine a few of the Morningstar report’s key takeaways to see why.

1. “Long term flows bounced back with $39 billion in inflows in January after $83 billion of outflows in December.”

Show this to the data analysts on your team and, if they’re worth their salt, they’ll tell you that such outliers should never be used to signal favorable trends. Market optimists might have you believe that the huge fund outflows in December were driven mainly by investors panicking during the end-of-year market retreat. But it’s just as likely investors were taking advantage of year-end tax-loss harvesting, selling shares as the market fell and repurchasing them in January after the 30-day wash-sale window had passed.

And the $39 billion in inflows seems less impressive when you compare it to the $132 billion in inflows to long-term funds in January 2018.  Look back over the course of the year and the figure is even less rosy, with only $56 billion in total net flows to long-term funds from January 2018 to January 2019 compared to $211 billion in inflows to money market funds during the same period.

2. “Passive equity funds fared worse than their active counterparts for the first time since January 2014.”

Ahh, so the market meltdown of December finally convinced passive investors to once again embrace the wisdom of active fund managers?

Hardly.

Active equity fund flows were flat in January, while passive funds had $3.8 billion in outflows. This blip is insignificant and certainly doesn’t signal a trend.

In fact, Morningstar admits that these passive outflows may be mostly attributable to start-of-year rebalancing of portfolios by target date funds, robo-advisors and managed portfolios, which tend to use passive ETFs and index funds more than active funds.   

3. “ETFS, which are mostly passive, took in just $2.5 billion overall in January versus $36.6 billion for their open-end counterparts.”

 Ah, so investors’ loyalty with ETFs is finally beginning to crack, creating a wedge for mutual funds to regain some of their lost market share, right?

Related: Active or Passive: Which Investment Strategy Is Better?

Related: Is Active Management Truly a Loser’s Game?

Again, take this short-term anomaly with a grain of salt. You’d have to go back to March 2018 to find a month where open-end funds had bigger inflows than ETFs. And over the past twelve months, open-end funds had outflows of $184 billion compared to $240 billion in inflows for ETFs.

Know the Flows

So what does a report like this tell you? That one-month results mean absolutely nothing, especially if they look like anomalies. And that there are often far more reasonable explanations for flow blips than a sudden shift in investors’ preferences.

And even the long-term overall flow results Morningstar and other researchers publish are less relevant than the specific flows for your fund category or asset class. Sometimes it makes more sense to ignore the big picture and focus on flows for your fund class to help you decide:

  • Do long-term inflows for my fund category look favorable?
  • Can short-term peaks and valleys in flows be explained by reasons other than fickle investor attitudes?
  • Is there room for my fund to compete against similar ETFs and index funds?

Investors are warned all the time to resist making bad decisions based on faulty analysis of short-term market trends. Asset managers need to heed the same advice. Failing to understand the big picture can lead to costly mistakes your firm can’t afford.

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