When it comes to investing, mutual funds have long been the dominant vehicle for most portfolios. Thanks to their inclusion in many workplace retirement plans, mutual funds have been able to gather trillions of dollars in assets and form the cornerstone of most investors’ portfolios.
However, their dominance has continued to erode in recent years.
The explosion in passive and index ETFs was the first blow, as investors realized mutual funds’ inefficiencies. And now the rise of active ETFs could signify the death knell for the investing vehicle. In fact, mutual funds’ expiration date could be approaching more quickly than we imagined.
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Surging Growth
On the surface, mutual funds’ continued growth looks bullish. However, that total asset picture is mostly due to the market’s continued surge over the last decade. Pulling back the curtain on inflows reveals a very bearish picture indeed. According to Morningstar Direct data, the 20 largest mutual funds shed nearly $793.4 billion in assets from net outflows over the last 15 years.
And it’s easy to see why. Exchange traded funds (ETFs) are simply better on a multitude of fronts. From tax efficiency and lower expenses to higher returns, ETFs offer a lot more than simply owning shares of a similar mutual fund.
Where mutual funds have lost the most ground versus ETFs has been in the active management space. The reasons outlined above have continued to provide additional performance for active ETFs, making them the vehicle du jour for investors specifically looking for actively managed portfolios. The proof is in the launches and fund flows. All in all, more than 466 ETFs launched during 2021, and the vast bulk of them – roughly 66% – were active ETFs.
Those fund flows hold the answer to the death of mutual funds, and State Street has the data.
Looking at fund flows for the last 15 years, active ETFs have had nothing but year-over-year inflows. Looking at monthly data, active ETFs are currently on a 21-month streak of consecutive inflows. However, active mutual funds have been trending the other way. Since 2015, they’ve managed to see outflows every year. Looking at the last 15 years, they’ve managed to see outflows in 12 of them.
When looking at the active management umbrella all together, mutual funds’ market share is now just 73% of the market – down from 88% ten years ago. The flipside is that active ETFs currently make up 5% of the market – up from just 0.40% a decade ago.
Why 2023 Could be The Year?
Clearly, there is a huge shift as investors realize the power active ETFs have over active mutual funds. And the fund flows tell a story as to when active ETFs might overtake active mutual funds to become the dominant vehicle. The critical year might be closer than we think.
Active ETFs managed to see a record inflow of $90 billion in 2021 – 44% greater than the record inflows of 2020. Looking at an eight-trend factor model and projected flows for the year, State Street estimates that active ETFs will see total assets of $420 billion by the end of 2022. That number rises to more than $600 billion by 2023.
There are some reasons to believe that State Street’s estimates could be on the conservative side.
For one thing, a huge source of active ETF launches has been mutual fund conversions and copycat funds. Prime examples are Dimensional Advisor’s recent conversion of several of its largest funds into ETFs or T. Rowe Price’s launches of clone ETFs run by the same fund managers with the same strategy. This is expected to be the norm going forward as most large asset managers – like J.P. Morgan, Capital Group and Franklin Templeton – have made announcements doing just that.
Secondly, 2023 is a critical year, as this is the expiration of Vanguard’s patent on ETFs. This patent allowed Vanguard to make ETFs a share class of its broader mutual funds, which led to asset gathering and tax efficiency even for the mutual funds themselves. With the patent now gone, analysts expect several fund companies to incorporate the technique into their active plans.
The end result is that by the close of 2023, active mutual funds will see a significant decline in their activity and overall demand. Investors just might not need them as the number of active ETF choices expands exponentially. Plus, there will be plenty of replacements for their portfolios.
And if active ETFs “crack the retirement account pot of gold” – another trend that could be expected to accelerate in the near future – it’ll really be over for mutual funds.
The Bottom Line
Active mutual funds have been on the decline for years now, but we may finally be hitting critical mass with regards to their demise. Fund flows, mutual fund-to-ETF conversions and new copycat launches are quickly adding assets to active ETFs. Thanks to these growth trends, mutual funds as the chief investment vehicle for most portfolios could be on their last legs.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.