Punished by another year of bad performance from active investment managers, there is some encouraging evidence that investors are finally wising up.
Call it the triumph of experience over hope, or simply a case of slow but steady learning, but last year equity-trading volume slumped and the flow of funds into low-cost options like exchange-traded funds continued to gain momentum.
A record $188 billion poured into U.S. ETFs in 2012, according to IndexUniverse, taking assets under management in ETFs to $1.35 trillion. The vast majority of the money is in low-cost index-based vehicles. While that's only about 12 percent of the $11.6 trillion industry, at least it represents a growing minority that is accepting the boring but rewarding reality that handsomely paid managers are not worth it because they are not going to consistently beat the market.
No two ways about it, the active management industry had a bad year, failing to keep pace with the S&P 500's 16 percent gain and the broader Russell 2000's 16.3 percent performance. Only 36 percent of funds outperformed their benchmark, down from 41 percent in 2011, according to an analysis by Goldman Sachs of $1.3 trillion in U.S. equity mutual funds. Just under half of large-cap growth funds beat their benchmark, while a pitiful 20 percent of large-cap value funds managed the trick.
And don't kid yourself that only "dumb" retail money goes into mutual funds, and the big boys and girls find their alpha in hedge funds. As of the last week in December, 88 percent of hedge funds were lagging the S&P 500. The average hedge fund logged a return for the year of just 3.5 percent, according to the HFRX Global Hedge Fund Index, a good sight better than their nearly 9 percent loss in 2011 but hardly the kind of reward you want for paying the standard hedge fund charge of 2 percent in fees and 20 percent of the profits.
And before you complain that hedge funds aren't benchmarked against the S&P and that the index contains many different strategies, check this out: not a single one of the nine main HFRX equity hedge fund indices beat the S&P or any of the other main U.S. stock benchmarks. In fact, the only one in double digits managed the feat backwards, as Short Bias funds lost nearly 18 percent.
Here, of course, is the part when people object, saying that the point of the exercise isn't to choose an average manager but one in the top echelon. I know of no compelling evidence that outperforming managers can sustain great returns, much less that an adviser can figure out who is going to get hot and when.
While plenty of wealth owners are still paying up for the chance of outperformance, a growing minority are opting out, at least in part. Last year saw strong fund flows into ETFs and record years for low-cost specialists like Vanguard.
Active mutual funds seem to be responding to a market which is turning away from their offerings. Expense ratios are in a long but slow decline, and turnover within funds is also falling. Expenses may be an effort to get more competitive, but falling turnover is a tacit acknowledgement that active management can have a hard time outrunning its costs.
That less frenetic trading is a trend is borne out by data from Nasdaq OMX, which reports that average daily U.S. equity trading volume was roughly 6.5 billion shares in September, compared to 11.3 billion in September 2008.
To be sure, any move towards more low-cost and passive investment can only go so far. For one thing, at a certain point a huge block of passive money will throw up great stock selection opportunities.
And of course, the active management business survives and thrives because it is easier and more fun to sell hope than to counsel contentment.
We also may soon get the kind of market event, in this case a huge bond sell-off, which sends investors hurtling back into equities. The key test then will be how much of the bond runoff goes active and how much passive.
For wealth managers, it is probably best not to count on an active management resurgence. Better instead to prepare for the trend towards low-cost to grow. That means keeping your own costs low and concentrating on service, long-term planning and tax advice.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)
(James Saft is a Reuters columnist. The opinions expressed are his own)
(Editing by Beth Pinsker)