Surge in exchange-traded funds might explain the woes at Perpetual, Magellan

Over the past 20 years, passive funds have received cumulative fund flows of $122 billion while active funds are flat on a cumulative basis with $3 billion in additional assets under management over the same period.

One of the main reasons passive funds have outstripped the growth of actively managed equities is the lower cost. An ETF costs about 0.25 percentage points, compared to between 1 percentage point and 1.5 percentage points for actively managed money.

Another reason that is arguably more important than cost is the inability of active managers to maintain market-beating levels of performance over time.

Tough spot to hold

Research published this week by S&P Dow Jones Indices found that regardless of asset class or style focus, active management outperformance is typically relatively short-lived, with few funds consistently outranking their peers.

S&P looked at all the top quartile fund management products in 2018 under the following categories: Australian equity general, Australian equity mid-cap and small-cap, international equity general, Australian bonds and Australian equity A-REIT.

Not a single fund managed to retain its position in the top quartile for the next four years.

Digging deeper into these numbers shows how hard it is to beat the market benchmarks. For example, in Australian equity general, 79 funds were in the top quartile in June 2018. The number in the top quartile fell to 34 in June 2019, 12 in June 2020, two in June 2021 and none in June 2022.

Australia appears to be heading down the same road as the United States where passive management through exchange-traded funds is gradually eroding the long-standing dominance of active equity managers.

In the US, passive funds now total $US10 trillion in assets under management, compared to $US14 trillion in active, which means market shares of 43 per cent and 57 per cent respectively.

In Australia, passive funds have significantly expanded market share compared to actively managed funds.

In October 2012, assets under management in passive funds totalled $54 billion, giving a market share of 16.3 per cent, while actively managed funds totalled $280 billion, or 83.7 per cent.

Today, the passively managed funds are more than four times larger at $230 billion, while the actively managed funds are $548 billion, or about double the size compared to 10 years ago.

At these sorts of growth rates, it won’t take long for the passively managed money to exceed 50 per cent market share.

Of course, owning an ETF and having exposure to an index or segment of listed companies representative of a particular industry is no guarantee of earning positive returns.

Chewing up returns

Also, low fees paid to the passive manager do not necessarily overcome entrenched high costs within a listed entity.

For example, the high fees and charges embedded within listed real estate investment trusts (REITS) can chew up a lot of the potential return to investors.

To illustrate this point, compare the returns achieved by Cbus, the industry superannuation fund specialising in property development and management over the past 16 years when it entered the property sector.

Its property units delivered a return to members of 14.92 per cent a year from June 2006 to June 2022. This includes a one-year return of 13.4 per cent in 2022.

Over the same 16-year period, listed REITS have achieved a return of 4.5 per cent a year, according to Bloomberg.

The S&P research, which is called the persistence scorecard, found that over the long term, poor performance by actively managed funds has proven to be a reliable indicator of future fund closures.

Across the five categories reported in the scorecard, about 40 per cent of the funds which placed in the bottom quartile of returns in the five years ended June 2017, were subsequently merged or liquidated over the next five years.

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