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Passive fund ownership of US stocks overtakes active for first time

Around 16 per cent of US stocks are held by index trackers and ETFs vs 14 per cent by actively managed funds

Passively managed index funds have overtaken actively managed funds’ ownership of the US stock market for the first time, data show.

Passive funds accounted for 16 per cent of US stock market capitalisation at the end of 2021, surpassing the 14 per cent held by active funds, according to the Investment Company Institute, an industry body.

The pattern represents a sharp reversal of the picture 10 years ago, when active funds held 20 per cent of Wall Street stocks and passive ones just 8 per cent.

Since then, the US has seen a cumulative net flow of more than $2tn from actively managed domestic equity funds to passive ones, primarily ETFs.

“It’s the latest milestone to fall [to index funds]. It’s been a slow build for decades now,” said Kenneth Lamont, senior fund analyst for passive strategies at Morningstar.

“It does raise questions of what the endgame is. Passive is only efficient as the active players in the market make it. We probably have some way to go before passive becomes less efficient, but it does raise questions as to where the equilibrium should be.”

The seemingly unstoppable rise of index-tracking funds has in turn helped fuel an unprecedented concentration of ownership — and thus voting power.

The five largest mutual fund and exchange traded fund sponsors — out of 825 in all — accounted for 54 per cent of the industry’s total assets last year, the ICI found, a record high and up from just 35 per cent in 2005.

The 10 largest control 66 per cent of assets (against 46 per cent in 2005) and the top 25 as much as 83 per cent, up from 67 per cent. The proportion of assets held by the many hundreds of managers outside the elite 25 has thus halved over the period.

The 10 largest fund houses manage the bulk of passive assets, and writing in its 2022 Factbook, the ICI attributed this surge in industry concentration to the meteoric rise of these funds.

Actively managed domestic equity mutual funds have suffered net outflows every year since 2005, even as their passive peers have had inflows every year bar 2020 and 2021. Index-tracking ETFs have proved more popular still.

US-listed ETFs, the overwhelming majority of them passive, have seen their assets rise fivefold to $7.2bn since 2012.

Growth was particularly strong last year with net issuance of ETF shares — which includes the impact of reinvested dividends as well as net buying — almost doubling from $501bn in 2020, itself a record, to $935bn.

Equity ETFs dominated with new equity issuance hitting $731bn, three to four times the level seen in previous years.

Overall, 88 per cent of ETF ranges saw positive net inflows last year, the ICI found, compared to just 48 per cent of mutual fund ranges, continuing a pattern witnessed over the past decade.

The number of ETFs available to US investors jumped by 398 in 2021, with 457 debuting — more than double the previous record of 197 set in 2015 — and just 59 were liquidated or merged.

In contrast, the number of mutual funds has declined every year since 2016. Stripping out money market funds, mutual funds have also seen net outflows of money for all but one year since 2015.

Lamont said it was unsurprising that industry concentration had risen against this backdrop.

As a result, the biggest houses “hold enormous [voting] power”, with some academics highlighting the “potential for oligopolistic collusion between these players”, he said.

Lamont lauded BlackRock’s decision last year to allow its largest clients to vote directly, reducing the fund giant’s proxy power. However he added that “it seems we are a long way away from individual investors picking preferences”.

Todd Rosenbluth, head of research at ETF Trends, said it was “easy to be fearful that more money is tied to a small number of firms”, adding that it was “imperative that these firms are as transparent as possible about their decision-making so investors can understand how their shares are being voted”.

Nevertheless he did not think the current level of concentration was harmful, and that instead the economies of scale it created had reduced costs for investors.

Rosenbluth was also relaxed about the rise of index investing, arguing that its “many flavours”, such as large cap, small cap and sectoral and style biases meant passive funds “are not owning the same assets”.

Vincent Deluard, global macro strategist at StoneX, a broker, was also unperturbed, arguing that “flows matter more than AUM and the passive sector has dominated flows for years”.

Demographic data suggest ETFs are likely to continue to grab market share from mutual funds. ICI data show ETF investors tend to be younger — with the average age of the head of the household 45, versus 51 for mutual fund owners — and wealthier, with average household income of $125,000 and household financial assets of $375,000, compared to comparable figures of $104,900 and $320,000 for mutual fund owners.

The current market dynamics may accelerate this process still further.

“If anything, every sell-off accelerates the rotation to passive. Investors sell actively managed funds first, while ETFs and index funds benefit from the mechanic demand of target-date funds,” said Deluard. “By default, all American savings are now invested in TDFs and rolled over into index funds.

“I expect the unfolding bear market will be very serious and will feature outflows from ETFs and index funds, but it will be much worse for the active sector. When the passive sector sneezes, the active sector has pneumonia,” he added.

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The CEO is leaving after less than two years on the job.

Call it the Brok Shock.

After less than two years on the job, Martin Brok is out as president and chief executive officer of Sephora and will be departing the company at the end of the month “due to a divergence of views,” according to an internal release obtained Friday by WWD.

Chris de Lapuente, the chairman and CEO of the selective retailing division of LVMH Moët Hennessy Louis Vuitton, who also oversees the group’s Perfumes and Cosmetics activities, will resume the position of president and CEO of Sephora while retaining his larger role.

The announcement took beauty industry insiders by surprise. “It seems abnormally abrupt, doesn’t it?” said one analyst, who spoke not for attribution.

Another insider said Brok, who joined Sephora after stints in top management positions at Starbucks, Nike, Burger King and Coca-Cola in Europe and the U.S., was never a good fit. “I don’t think it was a business issue — I think it was a fit issue,” said the source. “Sephora is a brand unto itself and when you take someone from out of this world, sometimes it works and sometimes it doesn’t. People think anyone can do beauty, but I don’t think that is totally true.”

“Starbucks is about efficiencies,” agreed an analyst. “LVMH is about luxury and the luxury experience

Brok, while Dutch, would admit even to those who first met him that he is often mistaken for being American given he went to university there and spent much of his career in the States. Outgoing and friendly, he has the confident (some might consider it brash) air of a successful executive who follows the American management method of “collaboration,” “team building” and unbridled enthusiasm for the company and the industry in which it operates.

De Lapuente, on the other hand, is British, smooth, genial and somewhat reserved. He rose through the ranks of Procter & Gamble, and was the group president of its global hair care division before joining LVMH as CEO of Sephora. A longtime beauty insider, he’s well-liked and respected by the industry.

He recruited Brok in September 2020 to be CEO after 10 years in the role. During his tenure, Sephora’s sales and profits tripled, its geographic reach expanded from 20 to 36 countries, its e-commerce business exploded and it established a foothold in China. In a Beauty Inc story last December, industry sources estimated that Sephora had 2020 sales of 7 billion euros, a figure that was expected to increase to 9 billion euros in 2021, versus 9.5 billion euros in 2019.

While both de Lapuente and Brok declined to comment on the figures, de Lapuente said Brok’s mandate was to “take it to the next level.”

Brok wasted no time in executing some high-profile moves, including inking a deal with the fashion and lifestyle e-commerce site Zalando in Germany to increase Sephora’s presence in that market and purchasing Feelunique, the prestige beauty e-tailer in the U.K., long one of Sephora’s target markets.

He also implemented a new global structure, promoting Artemis Patrick to executive vice president, global chief merchandising officer, and Deborah Yeh to global chief purpose officer.

During a lively fireside chat at the 2022 WWD Beauty CEO Summit in May, Brok laid out his vision, including doubling down on the wellness category and harnessing Sephora’s omnichannel capabilities globally. “Our opportunity is to take the innovation that is coming from across the globe —whether it’s home chat, same-day delivery, how we drive the personalization engine, the next evolution of the store experience, omnichannel services — and literally integrating those so that we leverage the power of the three regions we do operate in, let them be the drivers of the innovation and then scale across the board,” he said. “The opportunity now is for us to be able to do that faster.”

Consumers don’t see three separate Sephora brands, in North America, Asia and Europe. “It’s one brand across the globe,” Brok said. “What happens in one part of the world, in a nanosecond is communicated in another part of the world. So making that happen and ensuring we are delivering the same experience across the globe, the same drivers to grow, this is absolutely paramount.”

One beauty executive said that strategy may have rankled some key Sephora executives, who perhaps felt that it was encroaching on their territory or disagreed on how global structures should be set up.

Brok’s departure comes at a critical time for the retailer, the only global prestige beauty player. In Europe, Sephora is said to be preparing to reenter the U.K. market with brick-and-mortar locations outside of London, while China is starting to slowly reopen after pandemic-induced closures.

In North America, Sephora’s business is said to be strong — with continued momentum across all categories — but so is the competition. In its first-quarter earnings report, Ulta Beauty reported sales jumped 21 percent to more than $2.3 billion, with double-digit gains across all categories.

Meanwhile, Sephora’s partnership with Kohl’s Corp. is said to still be finding its footing. Industry insiders with knowledge of the business say that it is not yet at a level to replace the business lost as Sephora winds down its partnership with J.C. Penney.

De Lapuente is no stranger to Sephora. During his 10-year tenure as CEO he led the retailer to unprecedented heights. At the time of his promotion, LVMH chairman and CEO Bernard Arnault credited the executive with turning Sephora into a “global leader in prestige beauty retailing, recognized around the world as one of the most innovative brands in products and services, both in store and online.” Arnault also cited his success in growing new beauty brands, notably Fenty Beauty.

While bonds were out of favor for several months, many are now seeing better value in debt markets

Investors are going bargain hunting for beaten-down corporate bonds.

That is a reversal from earlier in the year, when investors sold off even the highest-quality debt. The turnaround highlights the tensions pressuring financial markets. In recent weeks, investors have grown more confident about the Federal Reserve’s path for raising interest rates to wrangle inflation—and more worried that, as a result, growth has begun to slow.

In May, as traders bid up bond prices, debt tracked by the Bloomberg U.S. corporate-bond index handed investors a roughly 0.7% return for the month, counting price changes and interest payments. That was the first time in 10 months that holding corporate bonds kept investors in positive territory.

Bond markets have had a rough year. Red-hot inflation makes the fixed payments offered by most debt investments less appealing. The Fed has been raising interest rates to try to cool the economy and fix inflation, but that has made investors demand higher returns for holding bonds, pushing down bond prices. The Fed is also unwinding its pandemic bond buying, which could suppress bond prices further.

But in the past few weeks, investors have started giving bonds another look, including corporate debt as well as U.S. Treasurys and mortgage-backed debt. Some investors prefer to buy the debt of blue-chip companies, such as AT&T Inc. or International Business Machines Corp. , because it offers higher returns than government bonds but with relatively little additional risk.

For some money managers, bond prices fell to levels too good to pass up in recent weeks. Others are looking for an alternative to stocks, which have had an equally bumpy few months.

The S&P 500 is down 14% this year. Stocks finished lower last week, with the S&P losing ground for the eighth time in nine weeks. The Labor Department said Friday that the U.S. added jobs at a strong but slower clip in May, and the Fed is closely monitoring jobs data as officials decide how to set benchmark interest rates in the coming months. One point of concern is that a strong labor market will further elevate inflation.

The debt of U.S. companies with relatively strong financial profiles is offering investors yield premiums, or spreads, of about 1.31 percentage points greater than what Treasurys offer, according to index data from Bloomberg. That number was as high as 1.49 percentage points a couple of weeks ago, but it has edged down as more investors seize on corporate debt as an alternative to the swooning stock market.

The spread was 0.92 percentage point at the end of 2021.

As inflation escalated rapidly earlier this year, so did investors’ guesses about how fast and how high the Fed would raise interest rates. That slashed the appeal of bonds because it suggested that higher yields on fixed-income investments would be available in the near future.

Now, higher yields have arrived. Inflation, meanwhile, edged down slightly in data released last month, and the Fed signaled that it plans to stay the course with the rate increases it had previously telegraphed. Some investors’ concerns have shifted more to the trajectory of economic output.

“A story began to build in the markets that now it was time to get more worried about growth than inflation,” said Andres Sanchez Balcazar, head of global bonds at Pictet Asset Management.

With the outlook for Fed policy over the rest of the year stabilizing, conditions for investing in corporate debt have ripened, said Matt Brill, the head of U.S. investment-grade credit at the asset manager Invesco. That has reduced the premium that investors demand for buying corporate bonds instead of putting their money in Treasurys.

“We’ve switched from playing more defense to at least being neutral and looking for offense,” Mr. Brill said. “The early parts of the year were about survival, but with where yields are and where spreads are, we feel more positive on the overall market.”

The uptick in bond prices mirrors a trend that has played out elsewhere in investment-grade credit markets, with buyers gaining confidence that higher yields and spreads are offering good compensation for the risks that could come with an economic slowdown. The higher spreads also make investors more willing to take on the risk of holding fixed-payment bonds even while rates are rising.

Government bonds rallied last month too. The yield on the 10-year Treasury note fell to 2.842% at the end of May, from 2.885% at the end of April, ending a five-month streak of losses for Treasurys. On Friday, the 10-year yield reversed course somewhat, climbing to 2.955% as traders digested the latest employment data. There have also been signs of growing appetite for bonds tied to government-backed mortgages.

May’s trading wasn’t the first time this year that investors piled into corporate bonds. In the second half of March, traders hit the buy button, and spreads fell rapidly, only to reverse course and move higher again in April. Arvind Narayanan, the co-head of investment-grade credit at Vanguard, said that the previous swing was mostly driven by technical factors in the corporate-bond market.

This time around, Mr. Narayanan said, smaller bond premiums likely reflect a genuine change in the economic outlook. That has given his funds and many others the confidence to jump back in as a buyer.

“We have deployed capital because we felt we don’t think a recession in the U.S. is imminent,” Mr. Narayanan said.

Another factor driving tighter corporate-bond spreads in recent sessions has been a notable dearth of new high-quality bonds for sale to investors by corporate issuers in the midst of the recent market volatility. Through last week, there have been 14 weekdays in 2022 when no companies with investment-grade credit ratings issued new bonds, said Daniel Krieter, a fixed-income strategist at BMO Capital Markets. That is the highest number of issuance-free days through the first five months of a year since 2015, he said. (The statistic excludes Fridays and the days of Fed board meetings, when issuance is usually light.)

With fewer new bonds coming to the market, the same pool of investors goes bidding for the limited debt that is up for sale, driving up prices and pushing spreads lower.

In all, corporations with credit ratings of BBB or better issued less than $100 billion of new debt last month, compared with close to $150 billion in a more typical May, Mr. Krieter said.

In a sign that corporate-credit markets could remain sleepy, the ratings firm S&P Global suspended its forward-looking financial guidance Wednesday, citing a slowdown in new bonds to rate.

“Debt issuance volumes have been extraordinarily weak year-to-date,” S&P Global said, projecting that the issuance of rated bonds could fall by up to 35% in 2022.