This investment trend you want to follow
(MoneyWatch) There's good news and there's bad news about mutual fund investors. First the bad: Despite the warnings that past performance isn't prologue, investors continue to be performance chasers. Some headlines never change, and like all things in life you have to take the bad with the good. So let's examine the good: Although it's moving at a glacial pace, there's an inexorable trend toward passive investing. Remember what they say about slow and steady? Though it's a subtle trend, it's still progress.
In its "2012 Annual Global Flows Report," Morningstar reported that 41 percent of flows into mutual funds and ETFs went into passively managed funds. In addition, they found passively managed funds experienced over three times the organic growth rate of actively managed funds -- 9.8 percent versus 3.2 percent. The net result was that passively managed funds now make up an estimated 18 percent of global mutual fund and ETF assets. In the U.S., the gap was even greater, with passively managed funds experiencing growth of 10.1 percent versus just 2.5 percent for actively managed funds.
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- The lies active managers tell
- How much of your bond fund is actually in stocks?
This is good news because there is an overwhelming body of evidence demonstrating that passive funds outperform active ones in all asset classes (not just "efficient" asset classes such as U.S. large stocks) and over all time periods. Investors have obviously become more and more aware of the evidence as passive U.S. stock funds have seen inflows, while active funds have seen outflows, every year since 2006. Their share of the U.S. market now stands at 26 percent of total open-end mutual funds and ETF assets, up from 12 percent a decade ago. The difference is particularly stark in the U.S. stock broad asset class, where 34 percent of assets are passively managed.
The good news wasn't just limited to the U.S. Double digit growth in passive assets also occurred in Asia (where passive funds have a 22 percent market share) and Canada (with a 10 percent passive share), while active funds grew just 1.4 percent and 3.1 percent, respectively. European investors also are seeing the light as passive funds there experienced growth in assets of 6.8 percent versus just 0.6 percent for active funds. Passive funds now have a 10 percent share of the European market.
The bottom line is that high cost, actively managed funds are "dead men walking". They just don't know it.
Performance Chasers Pay a Price
Despite its own admission, that ranking funds by expense ratios does a better job of predicting future performance than do star rankings, investors continue to pour money into highly rated funds. While five-star received $314 billion of net inflows, and four-star funds received $148 billion, three-star funds had net outflows of $173 billion, two-star funds lost $160 billion, and one-star funds lost $52 billion. Unfortunately, the evidence shows that investors tend to buy after great performance and sell after poor performance. Given that there's no evidence of any persistence beyond the randomly expected, this leads investors to buy high and sell low -- not exactly a winning or innovative strategy. It also leads them to underperform the very funds in which they invest. Morningstar estimated this "behavioral gap" at close to 1 percent a year for both stocks and bonds. They also noted that the more volatile the asset class, the worse investors do -- as they buy at higher highs and sell at lower lows. Like I said, some headlines never change, but that doesn't mean your investment strategy can't. Receive some good news for a change; take part in this growing trend. There's nothing passe about passive.
Image courtesy of Flickr user 401(K) 2013.