Passive Investing to Overtake Active in 2021, Says Moody’s

A credit ratings agency is saying passive fund investing will overtake its actively managed cousin in two years.

Moody’s Investor Service said it is seeing more buying of index funds, a lot of it from outflow from active funds.

The reason for the outflows, the agency said, is that a passive strategy is cheaper for investors and creates “less leakage earnings.” The “leakage” comes from management fees, commissions, and trading costs to brokers, and the risk of poor investment decisions made by managers. All of which lands on the investors.

Last year, an estimated $369 billion was pulled from long-term mutual funds, according to research firm the Investment Company Institute.

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The 2018 stock market volatility caused assets to crumble, but Moody’s said it theoretically should have “created more opportunities” for active managers to capitalize on downswings. Instead, it narrowed the gap in favor of index funds, which has steadily been widening since 2006.

“Prior to the downturn [in 2008], you were always hearing soundbites from the industry about how ‘you’re going to need active when the market goes down’ or ‘passive is just riding a bull market, and when the downturn comes, you’re going to see passive outflows,’” Steve Tu, Moody’s analyst who helped conduct the research, told CIO. “That narrative did not come to fruition.”

As of 2018, 36.7% of the US market accounts for passive investments. The firm decided 2021 will be the year investors in the US see index funds reaching 50%.

“That [2021] would be the crossover point for where the market share of passive increases to 50%,” Tu told CIO.

Other than pricing, a shift to passive investing has occurred due to more mergers and acquisitions occurring among funds, as well as an increased demand for more passive exchange-traded fund assets, or ETFs. As products that cater to the ETF industry grow, so does the value for passive shares.

The organization first noticed the growth momentum among index offerings in 2015, according to Brendan Mullin, the firm’s vice president. “To us, this is one of the biggest secular trends in the asset management industry,” he told CIO.

“The trend of active vs. passive is akin to the spread of the technology,” said Tu. “Others will say it’s based on some other dynamic. We view it as a more efficient technology. If it’s a better technology and more people that know about it, it’s going to spread over time.”

Moody’s also expects passive growth —and the ETF demand that goes with it— to spread further into Europe as regulations have made the strategy more attractive to retail investors. The European Union’s MIFID II rules last year provided more clarity on active fund fees, and also prevented funds from paying commissions to financial advisers. Currently, about 14.5% of the continent’s investors use index funds, but the credit agency said it will expand to 25% by 2025. Interest in the strategy has also been rapidly gaining traction since 2007.

“These changes will likely push retail investors toward cheaper passive funds, including ETFs, just as they become more widely available through investment online platforms,” the firm said. “European fund distribution has historically been dominated by banks that favor their own products, holding back take-up of ETFs relative to the US.”

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Tags: Active Investing, ETFs, index funds, Moody's, passive investing

As pressure on defined benefit pension plans mounts, many states have started to offer supplemental retirement plans to help public sector employees save for retirement. However, few of those plans have automatic enrollment, meaning participation rates are often low. A survey released today from the Center for State and Local Government Excellence and ICMA-RA shows that a significant portion of public employees would support auto-enrollment in supplemental plans, and a majority of them (77%) would stay in the plans once auto-enrolled.

The groups surveyed 400 state and local employees about their retirement choices. The results show that a shift is underway within public employee pension and retirement plans toward solutions that are widely available in the private sector, like auto-enrollment in supplemental plans. “What we saw when the South Dakota Retirement System shifted to auto-enrollment was that participation in the plan went up by 90%. That’s a really significant increase,” said Joshua Franzel, president and CEO of the Center for State and Local Government Excellence during a presentation of the findings to reporters.

Getting to a point where public employees are auto-enrolled everywhere may take some work, however. While a majority of respondents said that auto-enrollment would help them save more for retirement, 69% said they thought supplemental plans should be the workers’ choice and not that of the employers. Part of the disconnect may be the growing debt load that many people carry. Eighty-four percent of respondents said they carried some type of consumer debt and 67% said their debt or savings goals like buying a car or a house have prevented them from saving more for retirement. This problem is especially acute for low-wage employees. Still, keeping supplemental plans opt-in is risky. For employees that are new hires and potentially ineligible for a defined benefit plan, choosing to opt-out of a supplemental plan could mean forgoing retirement savings altogether.

This tension comes as no surprise to Sandy Matheson, executive director of Maine Public Employees Retirement System. In the 1980s, Maine’s public pensions were significantly underfunded and the state ratified changes to the state constitution to require yearly contributions and catch-up payments. As a result, the state was able to significantly improve the funded status of its public pensions and keep them going. But, she says, going forward, pension systems will have to rethink plan structure and benefits. “It’s all about how you allocate risk,” Matheson said during a presentation on the findings. “Our goal was to manage the plans and share the risk with our employees where we had to, but in such a way that they weren’t harmed. Other states are learning from what we did.”

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Source: Center for State and Local Government Excellence and ICMA-RA

Auto enrollment in supplemental plans, then, is just one part of a bigger picture. Michael Guarasci, chief financial officer at ICMA-RA, adds the findings highlight the fact that plan sponsors need to work to provide more resources to participants. “We think there needs to be more transparency and a greater understanding of what’s available to participants,” he said. “We also have to improve the products that are available so that participants can manage their retirement effectively.”

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Tags: Center for State and Local Government Excellence, Defined benefit (db) pension plans, ICMA-RA, Pension