Tidal Forces – Can active funds fight the passive flows?______

Calastone Global Report




Index tracking funds are steadily taking over the fund management industry, but their progress-to-date and the pace of change vary widely from one part of the world to another and across different fund segments and asset classes. In our latest global report, we analyse the investor trends that emerge from the hundreds of millions of trades that have passed across our network over the last two years.

The Calastone Fund Flow Index

Our Fund Flow Index (FFI) is a ready reckoner for comparing the popularity of different types of fund with investors. It compares net fund flows to total trading activity so that a small value of buying does not score highly in a big, actively traded fund category, but is rated as significant in a smaller one. A neutral score of 50 means the value of buys equals the value of sells. A reading of 75, for example, means the value of buys is three times greater than the value of sells. The FFI is also useful for comparing fund flows from investors in countries with small populations with those with large ones, or in territories where Calasatone has a dominant market presence v those where we are smaller.


Market Overview

  • Active funds still have much larger AUM globally than index trackers
  • Fund flows favour passive funds, but flows are small compared to the stock of assets so the shift is slow and incremental
  • Fund investors behave like fund managers – they trade active funds regularly but they buy and hold passive ones

The big picture

  • In an eventful 2020, equity fund trading on our network rose to $477bn, up 45% compared to 2019
  • Investors around the world sold down equity funds in 2019, but the net outflow was extremely small – worth just 42c for every $100 of transactions.
  • In 2020, the pandemic initially caused equity outflows, but from April onwards, a huge policy response from governments everywhere prompted £23bn of inflows, half of this in November and December as vaccine approvals began; for the full year, inflows equalled $3.79 for every $100 traded
  • Plunging interest rates between 2019 and 2020 prompted large inflows to bond funds

How index trackers and active funds fit in to the big picture

  • Index funds account for less than a fifth of equity fund turnover on our network, less than their share of AUM (active funds made up the rest); this is because investors are steadily buying
  • Net inflows for index tracking equity funds were $23.5bn in 2019 and 2020
  • High trading volumes in active funds reflect frequent decision making rather than popularity – active funds shed $5.4bn of capital over two years
  • Our index shows investors everywhere prefer index funds, but Europeans are most enthusiastic
  • Australians remain keen on active funds (alongside passive ones), especially those focused on the domestic market
  • Global funds are the one major category where active funds are attracting more capital than index trackers (though not among European investors)
  • Active emerging market funds are outcompeting passive ones in the UK and Australia, but elsewhere investors are opting for passive funds
  • Active European equity funds have suffered the biggest outflows as investors worldwide reduced holdings (their passive counterparts attracted modest additional capital)

Booming ESG funds are dominating equity fund flows, especially for active managers

  • ESG funds have taken $84 out of every net $100 flowing into equity funds in the last two years, a total of $15.1bn out of $18.1bn
  • UK and European investors have been the keenest buyers, but Asians and Australians are lagging behind
  • Three quarters of this new ESG capital ($11.3bn) flowed into active funds in 2019 and 2020; traditional active equity funds have shed $16.8bn

Active fixed income funds are beating index trackers

  • Unlike equities, inflows to active fixed income funds are consistently higher than for their passive counterparts by a ratio of 3 to 1
  • Active fixed income funds are especially popular with Asian investors

Market Overview

Chalk and cheese – active v passive funds

While active fund management attempts to beat the market, a passive strategy merely attempts to replicate its performance by owning all the shares or bonds in an index in exact proportion to their market value. Just as active fund management was born in the 1930s to provide the advantages of professional expertise, risk management and greater diversification for investors who had until then simply bought a handful of individual stocks and hoped for the best, so passive fund management, when it was invented in the 1970s, attempted to take human judgement out of the process altogether.

To outperform, a fund manager can employ one or more of the following tactics. can hold a concentrated portfolio of stocks (bonds or whatever) which she believes will outperform – the more concentrated the portfolio, the less diversified it is, so the higher the conviction must be. A decision to exclude one company from a portfolio is as significant as a decision to include another. This is stock selection. The second tactic is market timing, which attempts to manage a cash position actively – identifying dips in the market and using surplus cash to buy more of the favoured stocks, or taking profits at times when the fund manager believes the market has temporarily peaked. Asset allocation, the final tactic, recognises that one particular country, sector or asset class looks more attractive than another at any given time based on, for example, economic fundamentals or political developments. In the pursuit of these tactics active fund management implicitly recognises the need to buy and sell stocks more frequently. All of this activity comes with costs, in the form of brokerage fees, taxes and the bid-offer spread, as well as a larger overhead. The objective is that the performance will justify the fees.

Passive investing in its purest form does not employ these tactics, eschewing any attempt to outperform the market. It cannot eliminate market risk, but it resists all tinkering beyond the need to mirror the index exactly, limiting activity to buying stocks that enter a benchmark like the Hang Seng or MSCI World and selling those that leave it. Costs cannot be zero but the fund must minimise them, as these deduct from the overall return (even though some funds now charge zero fees, the fund still bears some costs).

Active funds still dominate the funds market

Active funds are still significantly larger than their passive counterparts in terms of assets under management, though there is wide variation around the world. In the US, where the category has the longest heritage, index tracking equity funds are almost as large as active ones [1], but in the UK and Australia, roughly $2 in every $3 is still actively managed. The figure is a little higher still in Hong Kong. But in Singapore active funds still represent almost the entire open-ended fund market. In fixed income, they remain more dominant than they do in equities.

The stock of funds under management is worth trillions of dollars whereas net flows each year are orders of magnitude smaller. Even very large differences between net flows for active and passive funds can therefore only drive change slowly and incrementally over time.

[1] Based on analysis of Lipper data of open-ended funds – excludes ETFs

Investors trade active funds regularly but buy and hold passive ones

Fund investors behave rather like fund managers when it comes to the way they trade active and index funds. Flows into index funds are relatively stable and buying has consistently outgunned selling, reflecting a simple ‘buy and hold’ strategy that accumulates savings over time. Net inflows are large by comparison to total trading volumes. By contrast, investors trade their active funds much more often, picking favoured funds, adding money more opportunistically in response to newsflow on economic, politics or world events, and re-allocating their assets around the world by switching between funds with a particular regional focus or favoured strategy. For active funds, total trading activity is very large and the resulting net inflow or outflow is extremely small by comparison to overall volumes.


The big picture

Huge increases in trading volumes in 2020

Between 2019 and 2020 our network saw $804bn of transactions in equity funds of all kinds in countries where we have a significant presence. Investors were particularly active in 2020 as they constantly assessed and reassessed the risks and opportunities presented by the extraordinary events of the year – mainly the pandemic, of course, but also the US election and geopolitical events like Brexit. Total turnover across our network rose to $477bn, up 45% compared to 2019. Fixed income fund turnover rose by a third to $250bn.

Net fund flows are small relative to huge trading volumes


In 2020 the year started with net outflows as the coronavirus infection took hold in China. Investors in Asia were first out of the blocks, extending selling seen at the end of 2019. Europeans jumped ship next, selling down heavily in February, while those in the UK took longer to respond, reflecting both the delayed arrival of the infection and the initial complacency of the UK government and population. It was March before UK selling reached its peak. From April onwards, as the huge policy response kicked in everywhere, money flooded into equity funds as asset prices were inflated by tumbling long-term interest rates. We saw net buying of $23.0bn between April and December, over half of which took place in the last two months of the year as vaccine approvals signalled an end to the crisis was in sight. Investors in Europe participated least enthusiastically in the end-of-year euphoria, reflecting the much poorer vaccine readiness across the region that dampened confidence.

Across the whole year inflows to equity funds were worth $3.79 for every $100 traded in 2020, a reading of 52.0 on our Fund Flow Index. For the full year, inflows were a net $19.5bn.

Fixed income saw stronger net inflows than equities, despite lower volumes, but real estate struggled

By contrast, though total volumes of trading in fixed income funds were significantly smaller in both years – a little over half the level of equity funds – net inflows were much larger. Between 2019 and 2020, investors added $48.5bn to fixed income funds, generating a very positive FFI of 55.5. Two thirds of this was added in 2019, when stock markets were weaker. Real estate funds struggled with outflows in both years, with selling activity almost twice as large as buying.

How index trackers and active funds fit in to the big picture

Index equity funds are on a roll

We do monthly deep dives into the fund transaction data in the UK and have identified a clear trend of accelerating inflows to index funds. Our analysis of global flows over the last two years is consistent with the patterns we have seen in the UK.

Over the last two years, index funds have made up just $1 in $5.36 of the volume of equity fund trades we process around the world. This is well below their natural share of assets under management but this is because trading is steadier, not because investors do not like them. Active funds by contrast are traded far more regularly and in greater volume reacting much more directly to global events. They accounted for 82% of the equity transactions by value across our network. Crucially, high trading volumes do not equate to popularity, but rather to much more frequent decision-making.

Index trackers are comfortably beating active funds in the race to attract new capital. Across our global network, they garnered inflows of $10.0bn in 2019 and further $13.5bn in 2020. The value of buy orders was almost two fifths higher than sells over the two-year period (FFI: Index Equity 57.8) indicating strong, consistent buying. Across every major territory and across every equity fund category, our indices of passive funds have outpaced their active equivalents in the last two years.

Active funds saw net outflows of $11.4bn in 2019 and would have shed cash again in 2020 were it not for a dramatic turnaround in the final quarter. Only by the middle of November had active equity funds finally recouped all the earlier 2020 outflows and, by the end of the year, investors added a net $6.0bn to their holdings.

The combination of lower trading volumes with steadier inflows for index trackers proves that investors are ‘buying and holding’. Index funds are now firmly cemented into savings plans, with automatic buy orders placed every month.

Some of the details vary, but trends around the world are similar

From one part of the world to another, passive funds are proving more popular. Investors in Europe and Hong Kong have withdrawn capital from active funds in each of the last two years, while adding to index trackers. Meanwhile, in the UK, investors committed a net $17.3bn to tracker funds between 2019 and 2020, while active funds shed $0.4bn. Taiwanese investors were net sellers of both active and passive funds over both years, but the outflows from active funds were fifty times larger.

Calastone Fund Flow Index of investor behaviour around the world shows preference for passive funds over time

Yet, even though the whole world is moving in the same direction, disproportionately adopting passive funds, this does not mean the value of inflows is necessarily always higher than for active funds. This depends more on the extent to which index trackers have become embedded in the local savings culture. For example, in Australia and Singapore, although index funds are scoring higher on our index, indicating steadier buying (in common with most parts of the world), the overall value of capital flowing into active funds is significantly greater. In Australia, inflows to active funds surged in 2020, totalling $3.7bn in new capital, compared to just $943m for passive funds. Over the last two years, active fund inflows in Australia have been three fifths higher than index trackers.

This is in sharp contrast to Australia’s UK, European and US peers, as well as some of its Asian neighbours and is being driven by buying of focused on domestic Australian equities and global equities. It also suggests the Australian active fund management industry may be mounting a more successful defence against the inroads being made elsewhere by index trackers.

Which equity sectors are driving the trends?

Across our network, global equity funds have proved the most popular over the last two years, consistent with a longer-term trend we have spotted in the UK. Although equity funds overall have only seen inflows of $18.1bn over the last two years, global funds have enjoyed $24.6bn of new cash, two thirds of this in 2020 alone. Unlike all our other geographical equity fund categories, active global funds have successfully fought off the competition from index trackers. Across our global network, investors have added a net $17.4bn to active global funds, two-and-a-half times more than the $7.2bn they have committed to passives. Only Europeans have favoured passive global funds. Investors have recognised the value of global diversification, freeing themselves from risks associated with single markets, such as concentration risk, where a few stocks dominate a stock market, political risks, or simply changing economic conditions, or to gain exposure to sectors not represented at home.

Index funds focused on North America have done very well too, with investors in all parts of the world adding to their holdings in 2019 and 2020, even as they sold down active North American funds. Emerging market funds have also seen inflows – investors in the UK and Australia bought active and passive emerging market funds in similar amounts, but those elsewhere focused on index funds, opting to withdraw capital from their active emerging market holdings.

The biggest negative impact has been felt in funds focused on European equities. They have borne the brunt of the selling, shedding $6.0bn over two years (four fifths of this was in 2019), with investors in every part of the world reducing their exposure to the region. Notably, all of this selling was in active European equity funds – sell orders over the last two years have been almost 1.5x greater than buys, generating an FFI: Europe Equity of just 41.9; their passive counterparts saw modest net inflows from investors everywhere, particularly in 2020. (An index reading of 50 means buys equal sells).

As with Australia, UK-focused funds have been unloved by foreign investors, especially those in the rest of Europe who have sold UK funds heavily. Brexit, the severe Covid-19 impact, and a stock market dominated by low growth value stocks that do badly when interest rates are at rock bottom, have all knocked the shine off UK assets. Even UK investors have only been interested in index trackers focused on their home market. They too have sold active funds.


Booming ESG funds are dominating equity fund flows, especially for active managers

ESG funds are the undisputed success story of the last two years for the asset management industry. From a near standing start, they have captured investor imagination to such an extent that over the last two years, they have taken an astonishing $84 in every net $100 flowing over our network into equity funds of any kind, a total of $15.1bn out of $18.1bn. Net inflows rose seven-fold between 2019 and 2020, even though overall turnover in ESG funds only doubled. The last four months of 2020 saw greater inflows than the rest of 2020 and all of 2019 combined.

UK and European investors have been the keenest buyers.  Our detailed analysis of ESG trends among UK investors over the last six years shows that a key moment came in late 2017 when environmental issues broke through irreversibly in the national consciousness and began to generate real change in attitudes to investment. Inflows have accelerated ever since. The effect in Europe has been similar. In the last two years, European investors have switched from non-ESG to ESG funds, selling $7.5bn of the former and buying $4.3bn of the latter.

Based on fund flows, Australian and Asian investors appear to be about two and three years behind the curve respectively, though appetite is growing. In Australia, discourse in the financial services industry is still more muted on ESG than in the UK and Europe, access to information is more restricted, and the home-market bias leaves investors with fewer assets that would meet global ESG standards. Across the rest of Asia, the speed at which attitudes are changing depends on the level of market development. MSCI’s APAC expert Jack Lin points out that the more investors feel they have ‘caught up’ with living standards in the rest of the developed world, the less they fear they have to ‘give something up’ in order to be responsible investors.

Three quarters of this new ESG capital ($11.3bn) flowed into active funds so the rapid growth is proving a boon to asset management houses under pressure from index funds. In fact, if we strip out ESG funds altogether then traditional active funds have shed $16.8bn over the last two years. The big challenge for active funds is to differentiate their products from index trackers and ESG is proving beneficial in pursuit of this aim. With ESG standards still evolving and much debate ongoing about the rigour of different benchmarks, many fund managers are doing their own detailed in-house screening of stocks, giving them a compelling marketing message.

As more and more asset managers launch ESG funds, fees have come under pressure, falling faster than non-ESG strategies. Research by Morningstar in October last year found that European investors are now paying less for ESG funds than for their conventional counterparts. Despite the fee compression, the fact that ESG funds are driving inflows is nevertheless very good for traditional fund managers.

ESG strategies have been a significant contributor to the success of active global equity funds. This makes sense because fund managers are not interested in where companies are but how they behave. They accounted for two fifths of the inflows to active global funds in the last two years. British investors have been by far the most enthusiastic adopters, with an FFI: Active Global ESG Equity in 2020 of 78.1 (meaning buys were almost four times greater than sells), but their popularity has grown in all parts of the world.

Passive ESG funds are growing too, though they are more expensive than conventional index trackers, and there remains a question over whether simply tracking an external ESG benchmark is rigorous enough for investors. Australians are lagging further behind when it comes to adopting passive ESG funds, while Asian investors have shown no interest at all.

Active fixed income funds are beating index trackers

Unlike equities, inflows to active fixed income funds are consistently higher than for their passive counterparts and totalled $36.7bn compared to $11.8bn in the last two years. Asian investors in particular favour active fixed income funds, but those in Australia and Europe have also added significantly more to active funds than index trackers. UK investors have slightly favoured index funds.

Tom Ross, a fixed income fund manager at Janus Henderson points out that active fund managers have advantages, especially in corporate bond markets. Just because a company has a lot of debt (and therefore gets a big weighting in an index) does not mean it is necessarily a sound borrower. Active managers can choose those companies with the best debt dynamics, rather than the most debt, picking those where the picture is improving most. Also, new bonds are issued all the time (much more often than shares) as old debt gets retired or new projects come along. There are better terms for investors who take part in a fund raising than there are for those who buy bonds on the market as passive funds have to. Moreover, passive funds cannot buy a newly issued bond until it is in the index so active fund managers can get ahead of them.

These advantages may explain why active bond funds are holding out more effectively against passive competitors.



Viewpoint – Edward Glyn

At Calastone, it is not our role to judge the merits of one particular fund over another – this is a job for analysts, financial advisers and the investors themselves. Because we handle such huge volumes of investor trades though, we are uniquely positioned to observe investor sentiment,  behavioural trends, and picking up/pointing out turning/tipping points long before anyone else is able to.

In Europe and the UK, Mifid II rules designed to provide investor protection and create more transparency on fees and costs have certainly fuelled investor demand for index tracking funds in the last three years, but there is also a strong argument that the long bull market has favoured passive investment too. Savers are quite happy to ride a rising index and take the simple market return: the MSCI World has roughly tripled in value since 2008. But passive investors are all-in on market bubbles and market crashes alike. Moreover, the rise of mega-caps like Apple and Amazon has increased absolute risk for passive investors, even if a fund continues to mirror the market perfectly. This is a sort of hidden risk.

In more challenging market times, many argue that active managers should be able to mitigate risk and capitalise on market volatility, therefore generating outperformance. Investors generally have greater aversion to losses than they have appetite for gains, and so they should logically opt for active funds in times of trouble.

There has not, however, been a sustained bear market for more than a decade, as even the convulsions caused by the onset of the pandemic were quickly sedated with enormous quantities of central bank liquidity and government cash. A full market cycle will eventually defeat policymakers’ attempts to stave it off, and then we will be able to judge if these arguments hold true or whether the shift to passive investment is a structural trend that will continue, whatever the prevailing market conditions, until a new equilibrium is found.

Beyond the cyclical arguments, it is not possible for passive funds to take over 100% of the market. Markets exist to discover prices. Efficient pricing of shares, bonds and other assets maximises the productive deployment of capital in the real economy. Price discovery is impossible if nobody is taking active investment decisions – the simplest example is that IPOs would become unworkable – how would newcomers be valued? Logically, the greater the share of passive funds becomes, the more opportunities active fund managers will have to identify mis-priced assets, enabling them to beat the market. Outperformance will drive inflows to active funds.

As Calastone’s global network expands to cover more and more countries and an ever-growing share of fund transactions in each market we will build an even more comprehensive overview of investor activity and look forward to sharing our insights.

A word about methodology

We have analysed hundreds of millions of buy and sell orders from 2019 and 2020, tracking monies from IFAs, platforms and institutions as they flow into and out of investment funds. A single order is usually the aggregated value of a number of trades from underlying investors passed for example from a platform via Calastone to the fund manager. In reality, therefore, our research tracks the impact of hundreds of millions of investor decisions each month.

We have not adjusted our figures for our market share. This varies widely from one country to another, but is over 70% in some territories. Any figures that appear in this report therefore only refer to volumes that pass over our own network. With such precise and granular data, we are nevertheless confident that the picture we are painting is representative of wider market trends

All figures refer to orders where they were placed, not where they were executed. Some markets like Australia see very little cash flow offshore. Others, like Taiwan, see almost all of it settled elsewhere. In the UK, about 15% of transactions by value takes place in funds domiciled offshore.


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