That is the provocative question asked by John Rekenthaler, a long-time big-wig with Morningstar in various capacities.
The fate of active funds (as opposed to passive index funds) is of more than passing interest to SMI readers, given that our Upgrading strategy is based on a thriving active fund universe. Without that, the dispersion in results that Upgrading has historically been able to take advantage of goes away.
Rekenthaler notes that over the past 12 months, 68% of the net sales from investors have gone to ETFs and passive funds, with just 32% to active funds. It's actually worse than that: $30 billion of the $132 billion that went to active funds was actually target-date money. In many/most cases, target-date investors aren't opting for active funds in making that decision, they're simply dealing with limited options. And if that's not bad enough, he writes, “Without international and target-date funds, active funds wouldn’t have picked up a dime of net new money this past year.”
With passive investing becoming the mainstream approach, another interesting question arises: could the market itself be altered if a high enough percentage of investing becomes indexed? It's not as crazy as it sounds, as indexers depend on active investors to ferret out the information that makes the market efficient (allegedly).
It's hard to deny the impressive traction indexing has at the moment, but my bet is we won't really know the answer to how this plays out until after the next bear market. Typically, active funds have performed better than index funds during bear markets. However, this really wasn't the case in the 2008-2009 bear market, when the selling was so steep and fast that everything just went down together.
Absent the advantage for active funds during that bear market, the current historical returns most investors are comparing today are extremely favorable to indexing, given that they include the 2003-2007 and 2009-2014 bull markets, with no "adjustment" back toward active management during the bear years in between. Most investors look at 3-, 5-, and 10-year returns, all of which lean toward indexing right now. The 15-year returns tell a different story, encompassing the more typical 2000-2002 bear market. While it's a mistake to rely on those long-term track records when picking funds, it's still how most investors operate. So if the next bear market is more typical in the active vs. passive dynamic, that may blunt some of the exodus from active to passive.
In any event, this is a trend we've been watching for some time and will continue to with great interest. Active funds have faced multiple challenges over the past decade: the brain drain of top minds to better paying hedge funds, the lack of a typical bear market performance gap to help even the performance record between active and passive, and the constant assault from ETFs and other passive funds. Obviously we hope the active fund market can stay healthy enough to sustain Upgrading and return it to its prior market-beating performance.