Brace for a wave of 'passive-aggressive' funds in 2022

One of the biggest trends in asset management masks a secret.

Passive investing has exploded in popularity over the past decade thanks to index funds, the holdings of which mimic benchmarks like the S&P 500 or specific themes like growth stocks. Unlike traditional mutual funds, regular index funds don’t involve a manager trading individual stocks or bonds, and instead rely “passively” on an external measure to automatically do the job. Marketed as a glide path for building wealth, with lower costs and higher returns, they're the poster child for passive investing, itself the vanguard of retail investing and retirement planning.

But increasingly, the hands-off image is a mirage, according to a new report from Cerulli Associates.

A Jan. 13 study by the Boston research firm details how fund managers are increasingly launching benchmark- and theme-tracking funds with an active component, in which the goal is not to sit back and mirror an external measure, but beat it. With a manager choosing stocks, bonds or other investments that she hopes will be winners within a given benchmark or theme and frequently switching up her holdings, active funds are typically more expensive for investors.

The new active funds cited by Cerulli as “poised for a pivotal year” of growth are exchange-traded funds, meaning securities that consist of bundles of shares and trade under their own tickers, just like shares in individual companies do. Both advisors and investors should be prepared to be love-bombed in 2022 with the products — and their higher costs and potentially lower returns, the Cerulli report suggests. For asset managers, “the active ETF opportunity,” report author Daniil Shapiro wrote, “is currently the most significant” — meaning that advisors and clients will see more of them.

Passive gets active
Boring, buy-and-hold index funds, sold both as mutual funds and as ETFs, are the opposite of meme stocks, day traders and legendary stock pickers like Fidelity’s Peter Lynch and Berkshire Hathaway’s Warren Buffet. So it’s ironic that the new breed of benchmark-related funds, known as active ETFs, is increasingly blurring the line between a passive approach and the active one favored by traders on day-trading apps. It’s a through-the-looking-glass moment for the asset management industry and is dubbed in some corners the “passive-aggressive” style of investing.

“Passive funds are becoming a little more like active,” said Todd Rosenbluth, the head of mutual and ETF research at CFRA, an investment research firm in New York.

Portfolio management

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Over the first 11 months of 2021, investors poured a record $794 billion in net new money into ETFs of all stripes, smashing the record set in all of 2020, according to Morningstar. Meanwhile, mutual funds are being left in the dust, as investors yank out dollars to shower cash on passive strategies. “The sun has begun to set on mutual funds,” said Ben Johnson, Morningstar’s director of global ETF research, in a Jan. 3 discussion on the company’s website. “ETFs are becoming the format of choice for a growing number of investors.”

What's in that fund?
Cerulli’s report said that seven in 10 fund companies that issue ETFs — BlackRock, Vanguard and State Street Global Advisors are the largest, according to Statista — are developing or planning so-called “transparent” active ETFs this year. Those funds readily disclose their daily holdings. But one in two fund companies plans for so-called “semi-transparent” active ETFs that don’t disclose their daily holdings, making them more like mutual funds, which lift the hood only quarterly. Fidelity has led the charge with the opaque funds using a proprietary method that evokes the days of Lynch, who ran its spectacularly successful flagship Magellan mutual fund from 1977 to early 1990. Investors should prepare in particular for a flood of sustainability-themed ETFs with a welter of environmental, social and governance (ESG) metrics, Cerulli said.

Both wirehouse brokers and independent advisors are increasingly jumping on the ETF bandwagon, Cerulli said. Rosenbluth called “quasi-active products” a way to “add value for your clients” at registered independent advisory firms.

As well as confusion and higher costs.

The issue, Cerulli said, is that active funds that aren’t transparent “complicate(s) the cost-benefit analysis, requiring additional diligence from advisors and home offices.” Translation: The funds may be more expensive, and for reasons neither an advisor nor an investor can readily see. Shapiro said in an email that while the average ETF fee in 2020 was 0.19%, fees for the new semi-transparent active ETFs start at a much heftier 0.4%.

Passive investing in theory curbs demand for ownership of individual stocks and mutual funds. But an Oct. 2021 revised study by researchers at the ULCA Anderson School of Business and the University of Minnesota found that the proliferation of passive index funds has reduced competition in the U.S. stock market by 15%. The evidence: “As more investors switched to passive investing, active investors didn’t increase their own aggressiveness” in buying individual stocks — a trend born out by declining mutual fund flows — the study said. Less competition can mean greater price swings.

That can spell trouble for passive investors in a market downturn as their funds adjust. “Most investors are used to a bull market, but just because you own an ETF doesn’t insulate you from a bear market,” said Lance Roberts, the chief investment strategist for RIA Advisors, a fee-only investment advisory firm in Houston. He cited the example of Cathy Wood’s ARK Innovation ETF, once a $60 billion fund of emerging technology shares that went from earning some of the highest returns in history to nosediving last year, all as the S&P 500 rose nearly 27%.

It’s all enough to make Roberts think that the concept of passive investing is itself an illusion. “There is no such thing as passive,” he said. “When markets are down, you are likely to sell, and if you sell, you are an active investor.”