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Why the Appeal of Passive Stock Funds is Declining

By , with Annuity FYI

When times get rockier and the bull market gets long in the tooth – the conditions today – active management is often better positioned to perform better and put more dollars in investors’ pockets.

Things change often in the financial markets, and sometimes these changes are significant. Just such a transformation has begun. Inflows into highly popular passive exchange-traded funds are slowing significantly while outflows from heretofore beleaguered actively managed mutual funds are dropping.

Investors who want to get the best bang from their non-annuity investments should take note.

Going forward, say a growing number of investment pros, well-managed active funds may increasingly buck a fading trend of typically underperforming passive exchange-traded funds. When times get rockier and the bull market gets long in the tooth – the conditions today – active management is often better positioned to perform better and put more dollars in investors’ pockets.

BlackRock as a Bellwether

This month, BlackRock Inc., the world’s largest asset manager and a bellwether of low-cost index-based investing, reported that investors radically slowed the pace of investments into index funds. In the second quarter, BlackRock garnered $20 billion in net investment flows – strong, yes, but down substantially from an inflow of more than $100 billion a year ago.

In the first six months of 2018, the amount of money going into all U.S. passive mutual funds and exchange-traded funds fell 44% from the same period last year, according to Morningstar, the financial market research firm.

At the same time, largely unpopular actively managed mutual stock funds are starting to outperform passive funds and slow investor outflows. According to Morningstar, 53% of such funds beat their benchmarks in the first four months of 2018, up from 49% last year and 29% in 2016.

Meanwhile, in the 12-month period through February, outflows from actively managed U.S. stock funds slowed by 15% compared to the year-ago period. Investment pros say this trend is accelerating.

Why the Popularity of Passive Funds is Waning

What is going on is that investors are growing skittish amid political upheaval in Europe, economic hiccups in China and worsening skirmishes over tariffs between America and its trading partners. These issues compound worries that stock market performance has been ho-hum this year despite soaring corporate profits, fueling concerns that the nine year-old-plus bull market is faltering.

When the stock market soared like a rocket last year, it made sense to invest in low-price index funds, many of which outperformed actively managed mutual funds anyway. Helping matters was that the Federal Reserve was still making cheap credit widely available, keeping many highly indebted companies in business. Buying high-quality companies didn’t matter much, and in any case there wasn’t much difference in the upward movement of individual stocks.

If the market weakens, of course, pretty much all stocks will weaken. But some will weaken more than others and some will still hold up relatively well, and this is where good active management shines. Sagely gauging the relative strength of individual stocks in a mediocre or weak market is usually more important than capitalizing on the lower fees and expenses and heightened tax efficiency of exchange-traded funds.

If you’re interested into looking into the homes of well-managed active funds, good places to start include Fidelity Investments, T. Rowe Price and American Century Investments.

You Can Still Stick with some Passive Funds

Two additional points should be noted.

Choosing between actively managed and passively managed stock funds doesn’t have to be an either/or decision. A number of people own both active and passive funds. This may include you. In this case, all you may need to do is change your balance of investments in these funds. It may make sense to invest in a big-cap passive fund that invests almost entirely in big-cap U.S. stocks and in managed funds that focus on less-efficient areas, such as stocks of small U.S. companies and international stocks.

The other consideration, given the stock market’s uncertain outlook, is whether you should stay in the market at all. The answer is that you should. Stocks remain the best long-term investment, and trying to time the market is a loser’s game. Unfortunately, too many investors do just that and, over time, wind up substantially underperforming stock market performance.

The bottom line is this: Stay in the market, but strongly consider portfolio adjustments if your portfolio includes passive funds. This way, you’re intelligently coping with change, not fighting it.

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