Many traditional active equity managers are vulnerable to a downturn in equity markets as rising stock prices have masked the underlying weakness of their business models, according to a report from Moody’s.

Moody’s believes active equity managers are vulnerable to a downturn in equity markets.

Stephen Tu, an analyst at the ratings agency, commented, “As equity market values have risen over the past decade, asset managers have experienced stable cash flow generation. However, the lack of organic AUM growth at a time when asset markets are at historical highs is a cause for concern.”

The report shows that outflows from US active equity mutual funds have accelerated in 2018 and are now at their highest year-to-date rate.

According to Investment Company Institute data on long-term domestic equity funds, which Moody’s uses as a proxy for active mutual funds, outflows from active equity funds totalled $129.1 billion as of 31 July 2018, up from $99.9bn a year earlier and $110.6bn in the same period to July 2016.

Source: Moody’s.

Although some active managers have argued that equity volatility should provide the need for investors to hold active funds, Moody’s outlines how active managers did not generally outperform during the heightened equity market volatility at the start of the year.

Citing JP Morgan research, Moody’s highlights that only 41% of active fund managers beat their benchmark in the first half of 2018.

Moody’s also notes that the continued decline in fees poses a further worry for traditional asset managers, with the average net expense ratio for active equity funds and active bond funds having declined below 60 and 50 basis points respectively.

This trend has been driven by the shift towards passive products, most notably ETFs, which tend to offer much lower fees. For example, the $15.2bn iShares Core S&P Total US Stock Market ETF (ITOT US), which tracks a broad index providing exposure to almost 3,500 US equities, comes with an expense ratio of just 0.03%.

Likewise on the fixed income side, investors can gain broad exposure through the $36.6bn Vanguard Total Bond Market ETF (BND US) which has an expense ratio of 0.05%. BND tracks the Bloomberg Barclays US Aggregate Float Adjusted Index, representing a wide spectrum – some 10,000 plus issues – of investment-grade, taxable, fixed income securities in the US including government, corporate, and international dollar-denominated bonds as well as mortgage-backed and asset-backed securities. It is listed on Nasdaq.

Passive’s market share stands at 34.8% as of year-end 2017, up from 31.8% a year earlier. The acceleration of the trend towards passive has resulted in its market share surpassing Moody’s base-case scenario estimates of 33.9% for 2017 and 31.0% for 2016.

Moody’s had previously forecast passive’s market share to overtake active by 2024 but current growth rates indicate that that milestone will be realized sooner.

Source: Moody’s.

While inflows into US equity ETFs thus far this year are at approximately half their pace for 2017, Moody’s believes this is reflective more of risk-off positioning amongst investors rather than decreased appetite for ETFs in general.

Tu said, “We believe that as investor risk appetite for equities fluctuates, the simpler characteristics of passive funds will cause them to have higher retention rates among long-term investors. With long-term exposures to passive investments, investors are typically making only one decision – whether or not to have long-term exposure to the equity market, or beta.

“In contrast, active fund exposure considers the additional element of a fund manager’s ability to beat the market. Investors make a qualitative decision about a manager’s ability to generate ‘alpha’, and changes to that perception could cause investors to redeem.”