Passive funds remain resilient despite market downturn

A passive expert at Morningstar points out why critics of passive investing were wrong to predict that volatile markets would cause investors to switch to active funds.

The year 2022 was brutal for investors. The list of negative factors impacting financial markets was long and scary: high inflationary pressures, a swift end to the decade of ultra-low interest rates, geopolitical and energy market tensions caused by the war in Ukraine, and ongoing concerns about the Covid-19 pandemic.

Financial markets closed the year with substantial losses and investors who relied on the old and trusted recipe of diversification of asset classes as an insurance policy were faced with the unnerving reality of seeing both equity and bond markets down. Cash was no refuge either, as rampant inflation attacked its value.

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All in all, a year to forget, unless one happened to be tactically overweight in energy – particularly fossil fuels – one of the few sectors to clock in gains, driven by rising prices on fears of gas and electricity supply shortages.

Undoing of passive has not played out

This environment should have seen the undoing of passive funds, or at least that's what the critics of passive investing had long prophesied. These critics summarily dismissed the success of passive investing over the past decade as nothing more than the result of riding the easy tide of rising markets. Once markets go down, investors will surely run, scared of tracking downward with no safety net, they said.

Well, the investor flows data for 2022 have said otherwise. The active side of the investment fund industry has seen a high wave of withdrawals on both sides of the Atlantic. In Europe, one has to go back to 2008 to see a worse year of outflows. Meanwhile, passive funds, and exchange-traded funds (ETFs) in particular, closed 2022 with net inflows (more money invested than withdrawn).

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In Europe, the ETF industry gathered around €80 billion (£70 billion) of new money, with both equity and bond ETFs seeing net inflows. This was down from €160 billion in 2021, but nonetheless a positive result considering that total assets under management in European ETFs fell to €1.32 trillion from €1.41 trillion in 2021 as a result of the capital losses sustained by financial markets in the year. The US ETF market saw a similar pattern, with net inflows of $594 billion, down from $911 billion in 2021, and assets down to $6.5 trillion from $7.3 trillion.

The resilience of the passive fund industry has confounded critics, but to be fair, market conditions were hardly conducive for active managers to deploy their skills. In particular, the breakdown of the negative correlation between equity and fixed income must have left many of these managers completely baffled.

Meanwhile, from an investor's point of view, faced with a situation when “everybody is losing money”, one might as well try to minimise the pain by keeping a tight rein on the only element they are at will to control, namely management fees. The low-cost nature of passive funds is likely to have been a key saving grace in 2022 as clearly many of those who, despite the headwinds, chose to remain invested in the market saw them as the least-worst option.

Having weathered the very choppy waters of 2022 in a fairly reasonable shape, the prevailing mood in the European ETF industry is one of confidence and ambition for further growth. For some of the larger ETF providers, this may translate into a stronger focus on the retail investor segment, which until now has not been a key priority in Europe.

Sustainability ETFs proving popular despite short-term performance pain 

The flows story of 2022 also told us that sustainability remains at the forefront of investors' minds. Just shy of two-thirds of net inflows into European ETFs were directed to products that Morningstar classifies as part of the sustainable sphere. This was remarkable in a year when sustainable investments overall underperformed non-sustainable propositions. Indeed, fossil fuels were one of the few bets to make money in 2022. In spite of this, most ETF investors in Europe made a conscious decision to see through this period of underperformance of ESG.

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This hints at a long-term strategic reallocation of capital towards sustainable offerings. In Europe, this is being encouraged by regulatory bodies, but the trend also feeds from a growing body of investors who see the incorporation of sustainability factors into the investment process as a default requirement in their fund selection process. European ETF providers have been increasing their sustainable product footprint to meet this demand, and we should expect this will remain a key focus of their product development plans in 2023. 

To conclude, as hard as 2022 has been for investors, the European ETF industry has emerged from it with renewed confidence, positive growth prospects and a clear strategic line in terms of product development.

Jose Garcia-Zarate is associate director passive fund research at Morningstar.