At US Stock Market Top Passive Funds Overtook Active Funds Ownership for First Time

A phenomenon consistent with the belief stock markets only go up is the ‘hold forever’ passive funds. At the end of 2021 these passive funds accounted for 16 per cent of US stock market capitalization. This overtook the 14 per cent held by active funds, according to the Investment Company Institute, an industry body. Significantly the all-time high of the US markets was seen at the end of 2021 and since then we have seen sharp selloffs. What I we need to see is how these passives these funds holdings are when the market fell back? Secondly, did these wanton passive fund feed the bubble and resultant blow off?

In the last 10 years the US has seen a cumulative net flow of more than $2 trillion from actively managed domestic equity funds to passive ones, primarily ETFs, FT reported. In those 10 years active funds have gone from 20 per cent to 14 per cent and passive funds have doubled in ownership from 8 per cent to 16 per cent of the US stock markets

Kenneth Lamont, senior fund analyst for passive strategies at Morningstar said “It does raise questions of what the endgame is. Passive is only efficient as the active players in the market make it. We probably have some way to go before passive becomes less efficient, but it does raise questions as to where the equilibrium should be.”

Funds greater control of assets

There are two aspects here the investor wanting to participate in the markets long term and secondly the collective aspect of shareholder control.

The five largest mutual fund and exchange traded fund sponsors accounted for 54 per cent of the industry’s total assets last year, the ICI found, a record high and up from just 35 per cent in 2005. There are 825 of these funds in all.

The 10 largest control 66 per cent of assets (against 46 per cent in 2005) and the top 25 as much as 83 per cent, up from 67 per cent. The proportion of assets held by the many hundreds of managers outside the elite 25 has thus halved over the period.

The 10 largest fund houses manage the bulk of passive assets, and writing in its 2022 Factbook, the ICI attributed this surge in industry concentration to the meteoric rise of these funds.

Financial Times

Actively managed domestic equity mutual funds have suffered net outflows every year since 2005, even as their passive peers have had inflows every year bar 2020 and 2021.

Most US Index-tracking ETFs are passive and have seen their assets rise fivefold to $7.2bn since 2012. THe bull market acceleration in 2021 saw the net issuance of ETF shares, including the impact of reinvested dividends as well as net buying almost doubling from $501bn in 2020 to $935bn.

Equity ETFs dominated with new equity issuance hitting $731bn, three to four times the level seen in previous years. They are not always a raging success investors were to find out, as the chart of the ARK Investment Trust Benchmark fund shows below, ARKK.

ARKK 2020-2022

Overall, 88 per cent of ETF ranges saw positive net inflows last year, the ICI found, compared to just 48 per cent of mutual fund ranges, continuing a pattern witnessed over the past decade.

Just like the SPAC and IPO boom the number of ETFs available to US investors jumped by 398 in 2021, with 457 debuting, more than double the previous record of 197 set in 2015 and just 59 were liquidated or merged.

It is worth noting with investors’ increased willingness to participate and apparently becoming more financially aware the number of mutual funds has declined every year since 2016. Stripping out money market funds, mutual funds have also seen net outflows of money for all but one year since 2015.

Lamont said the biggest houses “hold enormous [voting] power”, with some academics highlighting the “potential for oligopolistic collusion between these players”. BlackRock’s last year moved to allow its largest clients to vote directly, reducing the fund giant’s proxy power. However, Lamont added that “it seems we are a long way away from individual investors picking preferences”.

Todd Rosenbluth, head of research at VettaFi, an ETF data analytics company, previously known as ETF Trends, said it was “easy to be fearful that more money is tied to a small number of firms”, adding that it was “imperative that these firms are as transparent as possible about their decision-making so investors can understand how their shares are being voted”.

Demographic data suggest ETFs are likely to continue to grab market share from mutual funds. ICI data show ETF investors tend to be younger, with the average age of the head of the household 45, versus 51 for mutual fund owners and wealthier, with average household income of $125,000 and household financial assets of $375,000, compared to comparable figures of $104,900 and $320,000 for mutual fund owners.

This blend may continue in this direction even faster. We have seen the advent of brokers like Robinhood giving more exposure to smaller investor. Many with the collapse of stocks in 2022 have made the decision I want someone else to manage this leading to passive fund inflows.

“If anything, every sell-off accelerates the rotation to passive. Investors sell actively managed funds first, while ETFs and index funds benefit from the mechanic demand of target-date funds,” said Deluard. “By default, all American savings are now invested in TDFs and rolled over into index funds.

“I expect the unfolding bear market will be very serious and will feature outflows from ETFs and index funds, but it will be much worse for the active sector. When the passive sector sneezes, the active sector has pneumonia,” he added.

Vincent Deluard, global macro strategist at StoneX

We need to keep an eye on these flows and any flows into bonds or similar with the rising interest rates around the globe.

Source: FT

From The TradersCommunity Research Desk