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RETAIL QUICK TAKE: Active Funds Beat Passive Counterparts

Traders Magazine Online News, March 18, 2019

John D'Antona Jr.

For the first time in five years, active U.S. equity funds outshone their passive counterparts, with active U.S. equity funds balancing for the month while passive U.S. equity funds had $3.8 billion in outflows.

So saith Morningstar, in its most recent ETF fund report. Also, in the report:

  1. Overall, long-term flows in January bounced back with $39.0 billion in inflows after $83.0 billion of outflows in December, yet they trailed the past two January's hauls by wide margins, which were $132.0 billion in 2018 and $63.0 billion in 2017.
  2. Within Morningstar Category groups, taxable bond funds saw $31.5 billion in inflows this month, the group's best performance since January 2018. In contrast to equity funds, passive taxable-bond funds received a record $27.6 billion. Meanwhile, ultrashort bond funds saw their weakest month since September 2017, with the group collecting just $2.3 billion.

Gerry Frigon, President and Chief Investment Officer of Taylor Frigon Capital Management LLC believes that ETFs and passive investing are bad for investors, which is why the market is seeing a shift back to active investing.

“We believe that ETFs pose a potential threat to investors and to the efficiency of the market mechanism, and ultimately to true price discovery,” Frigon began. “They replace an investor’s ownership of securities issued by a business with a synthetic vehicle linked to securities by a process of financial engineering. This distancing of the investor from the portfolio of securities that the ETF is supposed to be tracking lowers the perceived need to scrutinize the securities in the underlying portfolio: in other words, it breeds complacency on the part of the typical investor in the ETF.”

He added that even an unsophisticated and relatively uninformed investor in an individual stock, for instance, acknowledges that someone should be performing careful analysis on that stock: with an ETF, many investors seem to believe (mistakenly, in his opinion) that careful ongoing analysis of the underlying securities and the companies that issue those securities is less necessary, or even entirely irrelevant.

“I suspect that many active managers would prefer to manage portfolios in which the trading is not driven primarily by arbitrage activities, Frigon said. “Because arbitrage by its very nature requires liquidity (in more ways than one), a temporary liquidity shortage could lead to the price of the ETF decoupling from the portfolio of securities it is supposed to be tracking.” 

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