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U.S. equity index fund assets have surpassed the assets of their actively managed counterparts for the first time, according to Morningstar’s fund flows report.

As of Aug. 31, the assets of mutual funds and ETFs invested in U.S. equity index funds totaled $4.27 trillion, more than the $4.25 trillion invested in actively managed U.S. equity funds.

Both categories saw outflows in August, but the outflows in actively managed U.S. equity funds, at $18.94 billion, dwarfed the outflows from U.S. equity index funds, which were less than a billion. For the year ended Aug. 31, the outflows from passive U.S. equity funds actually exceeded those from actively managed funds: $231 billion vs. $201.7 billion.

Over the 10 years ended June 29, less than one-quarter of actively managed U.S. equity funds outperformed their passive counterparts and just under half outperformed over the previous year, according to Morningstar’s most recent active/passive barometer.

Also contributing to the growth of passive equity funds is the increasing number of compelling quant-based smart beta and thematic passive funds that have replaced individual stock selection.

The growing popularity of passive funds has benefited those fund companies that focus on index funds, such as Vanguard and BlackRock, and hurt those companies that continue to stress active management, such as Franklin Templeton and Invesco. The latter two saw net outflows of $25.6 billion and $35.3 billion, respectively, for the year ended Aug. 31, while the former saw inflows of $170 billion and $121 billion during the same period.

Danger of Passive Shift Fed

The shift from active to passive investing is not without risk for financial markets and investors.

A recently updated report from the Federal Reserve Bank of Boston and the Federal Reserve Board acknowledges benefits from the shift: It may increase liquidity and reduce redemption risks in financial markets while cutting costs and improving performance for individual investors, since most active funds don’t outperform over the long haul. But the researchers warn that growth of passive investing also poses potential hazards.

The shift to passive magnifies industry concentration among asset managers, which can increase risks when one or more large firms have operational problems. It may also increase the correlation of returns and liquidity among stocks included in the same index and, in the case of leveraged funds, increase the volatility of financial markets.

It “is affecting the composition of financial stability risks … mitigating some risks and increasing others,” the report authors write.

Those effects could become more pronounced if the growing popularity of passive funds continues, and there is little evidence that it won’t.

From 1995 to 2018, cumulative net flows to passive mutual funds and ETFs totaled $4.7 trillion, compared with $2.0 trillion for active funds, according to the authors’ calculations based on data from Morningstar.

“This milestone has been a long time coming,” according to Morningstar. “Over the past 10 years, active U.S. equity funds have had $1.3 trillion in outflows and their passive counterparts nearly $1.4 trillion in inflows.”

That’s not the case for U.S. bond funds. Active bond funds still have far more assets than passive funds — $2.66 trillion vs. $1.45 trillion — although flows into passive bond funds over the 12 months ended Aug. 31 were almost 50% larger: $160.8 billion vs. $109.3 billion for active funds, according to Morningstar.

The Fed report, which essentially reviews research about the active-to-passive shift in fund assets, concludes with a call for more research on the impact on bonds when added to passive fixed income indexes, and differences in liquidity risk management practices between active and passive funds.

ThinkAdvisor.com Senior Writer Bernice Napach can be reached at bnapach@alm.com.