Vanguard, the world’s largest mutual fund company with more than $4 trillion in assets under management, had a smashing 2016. It was the top destination for investors, raking in net inflows of more than $277 billion that crushed its competition, according to a Morningstar report that tracks U.S. mutual fund and exchange-traded fund asset flows.

Investors also validated Vanguard’s core belief in index funds, injecting a record $505 billion into all passive funds — with half going to the company, the report said. Meanwhile, the typically costlier actively managed funds saw an exodus of $340 billion overall, widening the gap between active and passive funds.

Vanguard

Vanguard

Are actively managed funds — those led by managers who choose where to invest — on the way out? Vanguard CEO Bill McNabb does not think so. “The death of active may be overstated,” he said during a keynote speech at Wharton’s annual Rodney L. White Center for Financial Research Conference on Financial Decisions and Asset Markets. But he does see major shifts in the industry that call for a new way to do business. “The change in the economics of the investment management business is pretty profound.”

The numbers tell a grim story: From 2007 to 2016, the number of actively managed U.S. equity or stock funds fell to 2,223 from 4,351 — a survival rate of 51%. And a whopping 80% of active funds underperformed their market benchmark in the same period. Actively managed U.S. fixed income funds, those investing in bonds and other debt, also did similarly dismally. “This is not a positive thing for the industry,” McNabb said. “I view it as experimenting with other people’s money in many cases, which I don’t think is the right way to run a business.”

Even actively managed funds that do well tend to turn in uneven performances. McNabb noted that of 275 successful funds whose performances were tracked between 1998 and 2012, 97% of them underperform in at least five years in a 10-year stretch. Making matters worse is that tracked returns are generally better than what ordinary investors actually make in their portfolios.

“The death of active may be overstated.”–Bill McNabb, Vanguard CEO

Funds’ returns assume the money stays put. In practice, people who cannot stomach market volatility tend to move out of the fund too soon and move back too late, or sell low and buy high. Citing Morningstar figures, McNabb said investors’ actual returns are 1.5% to 2% lower than the fund’s posted performance.

The Shift to Passive Investing

McNabb traced the start of the major shift from active to passive  — funds that invest in an index such as the S&P 500, for example — to the dot-com bust of 2000 to 2002. In the years before the market collapsed, investors found it easy to make money if they invested heavily in tech stocks. “If you’re overweight in tech, you’re a hero,” he said. Growth managers loaded up on expensive dot-com stocks, betting on fast-rising startups, while value managers, whose job is to look for bargains with potential, forgot their core values and jumped into the expensive tech sector as well.

The result was a “trainwreck” as the dot-com boom turned into a bust, McNabb said. “Investors were really disappointed. People thought that by having an actual manager [manage their funds] they would do a little better. They actually did worse in most cases.” This experience not only changed investors’ attitudes, he believed, but also altered the way advice was given to ordinary investors. Financial advisers, who typically charge commissions, are shifting their compensation to a fee based on the percentage of assets. In 2000, 15% of advisers used asset-based compensation. Today, nearly 70% of them do it, McNabb said.

What also changed was the realization by the industry that fund costs are important when it comes to maximizing an investor’s returns. “Total costs became much more important in their value proposition to their clients,” McNabb said.

The industry saw the power of asset allocation over stock picking as well. How an investor divides funds into different investment buckets accounts for 85% to 90% of performance. Brokers used to give their clients a list of the best stocks or funds to put their money in, but the ability of money managers overall to pick securities was not consistently great, he said. “It began to be apparent to them that was a losing proposition to the client.”

Financial advisers began to pivot toward creating a portfolio for clients that followed an asset allocation model that was well balanced, diversified and fits their long-term goals, McNabb said. They also steered people towards low-cost funds to enhance client returns. He said funds with expense ratios, or annual fees, in the lowest quartile attracted $611 billion over the last 15 years while those in the top three highest quartiles lost $549 billion.

Advisers’ emphasis on asset allocation and low-cost funds “has been more the driver to indexing” than any academic research or marketing by Vanguard, he said. “I’ve never seen a marketplace move as quickly as this in my lifetime.” Not even the father of index funds, Vanguard founder Jack Bogle, had that kind of clout.

Robo and Personal Adviser Hybrid

But active management must change the way it does business if it wants to thrive, and McNabb offers a playbook. (Vanguard is known for its index funds but it also has actively managed funds.) Over 10 years, around 90% of Vanguard’s active fixed income funds and 83% of active equity funds have beaten their peers. “The reason for that has a lot to do with cost,” McNabb said. “Our active managers start out with large cost advantages.”

Vanguard’s analysis shows that the performance of traditional active equity funds is equally due to cost and the manager’s skill. Vanguard’s expense ratio is 0.37% for its average active equity fund, compared with 1.11% for the industry. In its active fixed income funds, Vanguard charges 0.17% to the industry’s 0.81%. “If you’re going to describe a playbook on the active side going forward, I think [low cost] is going to be part of the playbook,” McNabb said.

In particular, McNabb sees advisory fees falling. “I don’t think it’s going to be possible for advisers to keep an 80, 100, 120 basis point fee for providing investment advice going forward,” he said. Exacerbating matters is that finding good returns is also harder today due to the “professionalization” of the market, he added.

“If you’re going to describe a playbook on the active side going forward, I think [low cost] is going to be part of the playbook.”–Bill McNabb, Vanguard CEO

McNabb pointed out that in 1963, there were 284 chartered financial analyst (CFA) candidates and more than 80% of investor funds were not professionally managed. Today, there are nearly 178,000 CFAs and 68% of investor funds are in professional hands. That means there are more experts looking for investment opportunities, making it harder for anyone to gain an edge.

In 2015, Vanguard began offering low-cost financial advice to retail, or ordinary, investors through Vanguard Personal Advisor Services. It charges 0.3% of assets, which McNabb said was possible after combining advice dispersed by humans with “robo-advisors,” algorithms that tell investors how to allocate

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