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Announcement:

Moody's: Asset managers' active underperformance and new regulation drive shift toward passive investing strategies, flows to accelerate

25 Jul 2016

New York, July 25, 2016 -- Consistent net outflows globally from traditional actively managed mutual funds into lower-fee passive investment products are gathering steam and impacting the credit profiles of asset managers, says Moody's Investors Service. Persistent underperformance of traditional active management and new regulations are key drivers of the shift in assets to lower cost, passive products.

"Passive investments constitute roughly one-third of the US mutual fund market today, and we expect this share to expand well above current levels over next five years," says Stephen Tu, a Vice President and Senior Analyst at Moody's. "Looking ahead, absolute performance will be a more important consideration for investors than relative performance, given that the majority of active managers underperform their benchmarks."

Moody's report, entitled "Asset Managers -- Global: Industry Flows, Actively Moving to Passive," is available on www.moodys.com. The rating agency's report does not constitute a rating action.

Moody's considers overcapacity in active management to be a primary cause of investment underperformance. According to various studies, traditional active management has consistently underperformed, in all varieties of market conditions. Moreover, active funds' high fees are also more noticeable and impactful to investors in the present low-yield environment, accelerating the shift toward passive investments.

Meanwhile, regulators around the world have pushed for greater transparency on costs and more disclosure on fees and potential conflicts of interests. In the US, the Department of Labor's new fiduciary rule is likely to accelerate the shift to passive, and cause sales behaviour to change.

"Under the new regulation, advisors are expected to ensure investments are in the best interests of their clients, rather than merely suitable for them. In practice, it will become more difficult for advisors to place their clients into higher-cost and more complex investment products. Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interests and minimize fiduciary risk", says Mr. Tu. "In addition, the legal risks are highly significant in the new regulatory regime and will impose a higher bar on new sales of more expensive actively managed funds to retail investors."

Although some financial fundamentals remain robust for asset managers -- with industry-wide financial leverage still moderate -- earnings have weakened owing to the persistent, and now accelerating, flow of assets into passive investment products, and out of traditional mutual funds. According to Moody's, active management will likely have to shrink substantially over time in an attempt to improve performance.

Benefitting from the current trend are managers with a core competency in passive investment products, notably Vanguard (unrated), Blackrock Inc. (A1 stable) and State Street Global Advisors (a subsidiary of State Street Corporation, A1 stable). The scale and liquidity advantage that these firms have with core index products -- together, they have roughly 70% of market share in global ETF assets -- have created a strong barrier to entry for other firms.

Some traditional active managers are attempting to adjust their business models in response. A number of active managers that had not previously offered passive products have recently altered their strategies, and either made acquisitions or created new products to address the shift from active to passive investing. Among this group are Franklin Resources Inc. (A1 stable), Legg Mason Inc.(Baa1 negative), Janus Capital Group Inc. (Baa3 stable), and FMR LLC (Fidelity, A2 stable).

Many active managers view M&A as a strategy to address the passive trend. However, Moody's is skeptical, particularly given that in most cases acquisitions don't address the root cause of active underperformance since they don't reduce the amount of capital managed by active managers. Instead, Moody's anticipates a gradual repositioning of the traditional active mutual fund industry as a whole, including a re-emphasis on investment performance over growth and marketing, and more discipline in curtailing fund sizes and management costs.

Subscribers can access the report at: http://www.moodys.com/viewresearchdoc.aspx?docid=PBC_1035250

***

NOTE TO JOURNALISTS ONLY: For more information, please call one of our global press information hotlines: London +44-20-7772-5456, New York +1-212-553-0376, Tokyo +813-5408-4110, Hong Kong +852-3758-1350, Sydney +61-2-9270-8141, Mexico City 001-888-779-5833, São Paulo 0800-891-2518, or Buenos Aires 0800-666-3506. You can also email us at mediarelations@moodys.com or visit our web site at www.moodys.com.

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history.

Stephen Tu
Vice President - Senior Analyst
Financial Institutions Group
Moody's Investors Service, Inc.
250 Greenwich Street
New York, NY 10007
U.S.A.
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

Robert M. Callagy
VP - Senior Credit Officer
Financial Institutions Group
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

Releasing Office:
Moody's Investors Service, Inc.
250 Greenwich Street
New York, NY 10007
U.S.A.
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

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