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Asset managers’ active underperformance and new regulation drive shift toward passive strategies, says Moody’s

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Consistent net outflows globally from traditional actively managed mutual funds into lower-fee passive investment products are gathering steam and impacting the credit profiles of asset managers, says Moody's Investors Service.

Persistent underperformance of traditional active management and new regulations are key drivers of the shift in assets to lower cost, passive products.
 
"Passive investments constitute roughly one-third of the US mutual fund market today, and we expect this share to expand well above current levels over next five years," says Stephen Tu, a vice president and senior analyst at Moody's. "Looking ahead, absolute performance will be a more important consideration for investors than relative performance, given that the majority of active managers underperform their benchmarks."
 
Moody's considers overcapacity in active management to be a primary cause of investment underperformance. According to various studies, traditional active management has consistently underperformed, in all varieties of market conditions. Moreover, active funds' high fees are also more noticeable and impactful to investors in the present low-yield environment, accelerating the shift toward passive investments.
 
Meanwhile, regulators around the world have pushed for greater transparency on costs and more disclosure on fees and potential conflicts of interests. In the US, the Department of Labor's new fiduciary rule is likely to accelerate the shift to passive, and cause sales behaviour to change.
 
"Under the new regulation, advisers are expected to ensure investments are in the best interests of their clients, rather than merely suitable for them. In practice, it will become more difficult for advisors to place their clients into higher-cost and more complex investment products. Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interests and minimise fiduciary risk," says Tu. "In addition, the legal risks are highly significant in the new regulatory regime and will impose a higher bar on new sales of more expensive actively managed funds to retail investors."
 
Although some financial fundamentals remain robust for asset managers – with industry-wide financial leverage still moderate – earnings have weakened owing to the persistent, and now accelerating, flow of assets into passive investment products, and out of traditional mutual funds. According to Moody's, active management will likely have to shrink substantially over time in an attempt to improve performance.
 
Benefitting from the current trend are managers with a core competency in passive investment products, notably Vanguard (unrated), Blackrock Inc. (A1 stable) and State Street Global Advisors (a subsidiary of State Street Corporation, A1 stable). The scale and liquidity advantage that these firms have with core index products – together, they have roughly 70 per cent of market share in global ETF assets – have created a strong barrier to entry for other firms.
 
Some traditional active managers are attempting to adjust their business models in response. A number of active managers that had not previously offered passive products have recently altered their strategies, and either made acquisitions or created new products to address the shift from active to passive investing. Among this group are Franklin Resources Inc. (A1 stable), Legg Mason Inc.(Baa1 negative), Janus Capital Group Inc. (Baa3 stable), and FMR LLC (Fidelity, A2 stable).
 
Many active managers view M&A as a strategy to address the passive trend. However, Moody's is sceptical, particularly given that in most cases acquisitions do not address the root cause of active underperformance since they do not reduce the amount of capital managed by active managers. Instead, Moody's anticipates a gradual repositioning of the traditional active mutual fund industry as a whole, including a re-emphasis on investment performance over growth and marketing, and more discipline in curtailing fund sizes and management costs.

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