Welcome, everyone, to the 80th edition of Bogleheads on Investing. Today, my special repeat guest is Jeff Pitek. Jeff is a charter financial analyst and managing director for Morningstar Research Services. In this episode, we'll discuss major trends in the mutual fund industry with emphasis on the hottest area, actively managed ETFs.

Hi, everyone. My name is Rick Ferry, and I am the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center for Financial Literacy, a nonprofit organization that is building a world of well-informed, capable, and empowered investors. Visit the Bogle Center at BogleCenter.net, where you will find a treasure drover of information, including transcripts of these podcasts.

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In this episode, we're welcoming back Jeff Pitek. Jeff is a charter financial analyst and the managing director for Morningstar Research Services. Prior to that, he was the chief ratings officer. And prior to that, he was head of global manager research. Jeff was a guest on episode 33, where we discussed the state of the mutual fund industry at the time.

In this episode, we'll venture into new trends affecting the mutual fund industry with special focus on the exponential growth of actively managed ETFs. So with no further ado, let's welcome back Jeff Pitek. Welcome back to Bogleheads on Investing, Jeff. Oh, Rick, thanks so much. It's a pleasure to be here.

Well, a lot has happened in the mutual fund and ETF industry since I had you on a few years ago. It's really accelerated, especially ETFs that have come out and the number of companies that are creating ETFs now. So today we want to go over the state of the mutual fund and ETF marketplace.

Look at the new funds that are opening, funds that are closing. We'll get into the active versus passive debate again. I mean, is this helping? And we'll talk about some portfolio management items at the end. Why don't we start out with the state of the mutual fund and ETF industry?

Sure. I think it's a picture of a vibrant industry, but there's a dichotomy for sure. When you look at what's growing and what's contracting. So let's start with what's growing. Indexing writ large is growing. ETFs is a category within indexing is growing. And then even within ETFs, you're seeing active investing growing, which is probably something maybe we'll touch upon a little bit later in the conversation because that's a burgeoning area.

And then what's on the flip side? It's basically the opposite of each one of those things. You're seeing active in many areas contract. You're seeing open-end funds as a category shrink further. And the convergence of those two things, active mutual funds have really been under siege in recent years.

So it's an industry that continues to grow. And in fact, just by virtue of the market, even active open-end mutual funds have seen growth, despite the fact that some of them have seen prodigious outflows over time. But you're seeing some real puts and takes. So let's get into the numbers here.

How many mutual funds have been created versus how many ETFs have been created, say, over the past three years since I had you won last? Okay. So in terms of mutual funds that have been created over the last three years, around 1,300 have been created. Does that include money market funds, too?

No. I'm sorry. I should have mentioned that. So that's just sort of your traditional sort of stock bond allocation funds. No money markets included in that. And then if you're to focus on ETFs, there were around 1,700 ETFs that were created over the last three years. So you've seen more creation within the ETF industry than you have in the fund industry.

And so probably something you're wondering about, what about the converse, you know, the number of funds that have been mothballed. And this is pretty striking. So with respect to open-end mutual funds, around 4,400 have been merged or liquidated away in the last three years compared to 642 ETFs. Wow.

And so it's a picture of an ETF industry that continues to expand, not only by assets, but in terms of net number of vehicles. And then with respect to open-end funds, you're actually seeing the industry contract. There were a number of years, as you well know, where the industry was growing like wildfire, both in terms of assets, as well as in terms of number of funds.

But it's actually been shrinking in recent years. And you could argue that that's an industry that's adapting to a more sobering set of conditions than it faced in the past. So I just want to make sure I heard this correctly. Open-end funds, traditional open-end funds, whether it's indexed funds or actively managed funds.

1,300 approximately have been created in the last three years and 4,400 have closed? That's correct. Wow. That is a huge number. Did it include different share classes like A-share, B-share, Z-share, I-share? Are those part of the 4,400? Indeed, it did. So this is all share classes. And so you're right that some of this can be share class consolidation, of which there has been some.

At the margins, there can also be a little bit of open-end ETF conversion activity that you might have seen take place in the last three years that's picked up a little bit. That's more of a rounding error in that number. It's more about the economics of running money in the open-end format.

A lot of these, they're smaller in size, or they just want to tidy up their lineup, close some share classes so that they can gain a little bit of scale across a fund's various share classes. But yeah, the open-end fund industry is in contraction. You did mention something I want to bring up here, and that is converting from a traditional open-end fund to an ETF.

How many funds have done that? And is that a growing trend? It is a growing trend. In terms of numbers, I don't have it right in front of me, but we're talking about hundreds of funds that have been converted. Hundreds, wow. Yeah, there's been a good number of them.

What we have tended to find, with a few exceptions, is that the traditional fund providers, who are the ones that are typically converting these, they are picking and choosing which they're going to convert. So they might have a colossus of a fund within their lineup, but it might have a lot of assets in the retirement channel, or it might be spread across a multitude of different share classes.

In circumstances like those, it doesn't facilitate conversion because you can't have an ETF in a 401k plan, or it's just a logistical nightmare to go and basically consolidate the multiple share class assets into a single share class so that it can be converted to an ETF. So what it's tended to mean is that fund companies have been more picky about what they convert.

But we have seen some large fund families that have converted, probably most notably Dimensional, has converted a number of their mutual funds, and that's real money. There's been significant, we're talking billions of dollars in assets that have converted. JP Morgan is another name that springs to mind. But then we've also seen some traditional, very large open-end active players who've opted to go a different route, just launching DeNovo, like good examples of that.

Probably the most prominent would be capital group, capital group, also known as American funds. They brought out a number of active ETFs, and those are not conversions. A few years ago, Vanguard held this patent on being able to launch an ETF share class against their traditional open-end funds. That's how VTI, the total stock market ETF, and VTSAX, which is the total stock market fund, are the same fund, just different share classes.

And for many years, almost 20 years, Vanguard owned a patent on this, and no one else could do it. That came off patent, I want to say, a couple of years ago. And I've seen a lot of companies doing that. Is that something that's a trend? Not yet. Because I believe that we've got a number of fund companies that have applied to the SEC to do this.

My colleague Ben Johnson has done a really good job of chronicling this. I think there's dozens of fund companies at this point. But what we have typically seen the traditional active providers do is either convert, like we had talked about before, or they will just bring out sort of a version of an active strategy that they offer, but it will not be a just sort of a new share class that sprouts from the existing fund, if that makes sense.

So if you've got like a fund that's got like four or five share classes to it, we're not yet seeing them at that fifth or sixth share class, the fifth or sixth being an ETF. It's a new offering essentially that resembles maybe the traditional open-end fund that they offer, but isn't an exact replica like you would have if they just sort of sprouted a new share class.

And is that because it's still in SEC registration, and the SEC is working on it, and that's the reason why this hasn't happened? That's right. But I know that it's awaiting regulatory approval. I think that there's also an operational dimension to this for some fund companies. But as Ben has done a really good job of chronicling, that hasn't stopped many of them from going and applying for this, notwithstanding whatever sort of operational hurdles might stand in their way, clearly they feel like they can surmount those challenges.

Let's look at some of these new offerings. I'm a casual observer of some of these new ETFs that are coming out, and there are a lot of interesting ones. Very niche, very specific, even single-stock ETFs leveraged. So let's go ahead and start at the top of the three categories that I found.

The first one is thematic funds. It seemed to be very popular. Yep. So thematic funds, you're quite right. That has been a very popular category. I would say it peaked a few years ago back, probably 2021. I think that we saw 57 thematic ETFs launch it since tapered off a bit.

For instance, in the last year ended February 25, there were only 17 new thematic ETFs that were launched. So it's definitely cooled down. And I think that's attributable to a couple of things. I mean, one is, I think the industry maybe got shook out a little bit. 2022, by the market downturn, which hit some of these strategies really hard, and even some of them hit a harder times even before that.

I think the other factor is investors have had some difficulties using these successfully. I did a little bit of work on this a month or so ago, looking at how the average dollar invested in thematic strategies had done over a period of time. I think I looked at the trailing three years, maybe as of January.

And what I found is that the average dollar had lost money, despite the fact that it was a pretty hospitable market climate. What's more, you found that the average dollar in thematics, not only did it lose money, but it badly lagged how the average dollar had done in just a plain old target date 2050 fund.

You know, I picked a 2050 because it's a lot of 25, 30 year time horizon, which mimics what you'd see with a thematic. And those made good money. It was like 67%. So it was basically a 14% per annum difference in the return to the average dollar of a thematic.

And I, so I think the fact that, you know, you've had these very divergent sort of experiences, sort of rates of success in thematics, that probably also has induced some of the slowdown that we've seen in those, but they're a big category. They have at last count around $113 billion in net assets in thematic ETFs.

And so the fact that there's a good amount of money there, there's been some legs of growth to it. It'll continue to attract some activity, which we've seen, like I said, 17 of these launched in the last year. A lot of times these thematic funds, which might be artificial intelligence or that, whatever the theme is, the investment theme is of the fund, there's a lag.

I mean, it gets hot, it gets popular. I've been, I've been around the industry for almost 40 years now, and it's constant, right? If something is hot, then a fund eventually gets created, but it does take time to get the offering through the SEC. Exactly. So by the time the fund launches, the shooting star is beginning to burn out in a way.

That's right. Exactly. By the time it gets to you, by the time it resonates with you, I mean, that story might have been played out. Those of us that have been inculcated in sort of passive investing and market efficiency, even in perfect forms of it, I think that one of the first questions we go to is, well, why wouldn't this have already been priced in, right?

And so I think that's one of the difficulties that investors in these products have encountered. And just to, so it's a little bit less abstract. I mean, just looking at the top products, China internet, cyber security, US infrastructure, Dow Jones internet, arc innovation, which is probably the most famous of these medical devices, cloud computing, exponential technologies.

I mean, these are the sorts of stories that basically make up these types of strategies. And in most of these instances, at the time they launched, that was a story that kind of had entered the zeitgeist, had its hold on a segment of the market, and yet it was probably already priced in and then some.

And that's why it hasn't conferred the sort of outsized returns that maybe one would have thought it would have given how hot these themes were at the relevant times. Hmm. Solar energy, cannabis companies, all of that. That's right. Uranium, artificial intelligence, which you mentioned, water resources, quantum investing, if we can even call it that.

These are all examples of thematic strategies one would find. I remember reading a book about fidelity years ago, it was published, must have been 35 years ago, with the authors quoted. I think it was Ned Johnson who said, you know, if the public will buy it, we will create it, but I wouldn't put a dime of my own money in it.

Yep. No, no, for sure. And I think I did maybe write a little bit about this in the piece that I wrote, the headline of which is that the average dollar in these thematics had badly lagged, the average dollar in target date 2050s. If you're going to do it, and it seems strange to say this, you want to be a bit contrarian about it.

Like if you believe in the theme, you've done your homework, you think that there's some durability to it. Well, probably the time to get in is after it sells off. And it's more invitingly priced, not when it's basically cocktail party chatter, that sort of thing. Very good. The next group leveraged ETS.

And these can get very specific, like 2X, 3X up, 2X, 3X down, and even get into single stocks. This is getting to be popular. Yes. To say this category would leave Bogleheads colds is, I think, the understatement of all understatements. So yeah. So maybe a few facts and figures that I'll hang on this one.

There were, last year, dozens of leveraged ETFs come out. And why did the number pick up? Because one of the emerging trends that we've seen in that space is single stock leveraged ETFs. So think of Nvidia, think of MicroStrategy. I mean, typically, these are kind of growth names. They've got some curb appeal to them.

And they attract the trading crowd. And that's really what these ETFs are designed to appeal to. And so, but the new wave in these have been single stock leveraged ETFs. You know, this is something else I wrote a little bit about. There was a piece that went up a bit, just, you know, focusing on, this was as of early February, the sorts of results that it looked like investors had seen in products like these, again, focused on the average dollar, which is sort of an internal rate of return calculation, dollar weighted return calculation.

And what you found is if you actually took the reference assets, whether it's a single stock, like it could be an ETF, more commonly, it's an index, and you just basically ran their return without the leverage, you only earned about five percentage points more in these products than would have the underlying assets without any of the leverage and certainly with far less volatility.

So granted, these are not really built for somebody that's going to hold for a year, which was the time period that I examined in my study. But I think it does underscore the fact that there's real issues with these. The providers, they certainly disclose that these are designed for a single day, and you should not expect to be able to earn some multiple over periods longer than a day.

So they're fulfilling their obligation. But you know, it does seem that that probably there are there are investors who stick in these for longer than that. And they probably are doing so to their detriment because there's more volatility. There's certainly more fee. I do see that when a new person comes to me and I look and see what they own.

Occasionally, I'll see a 2x or 3x. And they've held it for quite a while. And their rate of return isn't 2x or 3x because there's also 2x and 3x volatility. And when you compound volatility, you erode away whatever excess return there is. That's right. The SEC has put out multiple advisories to investors on these funds, and even put out warnings to broker-dealers, because I remember in the past some broker-dealers got in trouble for not telling the clients how risky these things are.

Just be careful with these things. They are meant for one day, which is really a bit strange because it really kind of circumvents the margin laws. You could leverage something within a fund without actually having to have a margin account. It's not something Bogleheads probably would be investing in, although I have seen a few of them in accounts.

The last category I want to discuss is private equity inside an ETF. And the big one is SpaceX, right? Now you can own SpaceX if you buy this ETF, even though SpaceX doesn't trade. You wrote some on this. So this is maybe one of the hottest themes going, the public-private convergence.

For the record, I don't have an issue with the notion of investor investing in both public and private, as long as they understand the associated trade-offs. What's been new is ETFs and open-end funds entering this space. The reason why it has not been common to this point, as we know, these are daily liquidity vehicles.

They need to be able to fulfill buy and sell orders. And so what that means is that the underlying securities they invest in need to be sufficiently liquid and have readily ascertainable market values. And that doesn't really describe private equity or private credit for that matter. And my colleagues, especially Jack Shannon, have done lots of work on open-end funds that have owned stakes in private equity.

Some of the big complexes, Fidelity, T-Row, and the like, they do have positions in private equity in their open-end funds, but they have tended to be at the margins. And Jack has done a really good job of covering that for us over time, as did Katie Reichert before him.

I focused on a newer ETF. It's called ER shares, private public crossover ETF. The ticker is XOVR. And what's notable about what it's doing is it is committed to investing more meaningfully in private equity up to the 15% limit on a liquids. And to do so, it took a sizable stake in SpaceX.

It's around 11% of its net assets. And that's a pretty chunky position in an illiquid for an ETF to have. And so what I try to do with the piece is just kind of go through the progression to ask the questions that I would think somebody that's diligently a product like that would ask themselves, which I think it's probably advisable for us to all ask as this sort of trend plays its way through open-end funds in ETFs.

It's questions like, how do they access and transact in the private equity securities concerned? How do they value it? How do they manage the associated liquidity risk? I mean, when you're kicking the tires on vehicles like those, there should be sort of satisfactory answers that are forthcoming on each of those questions.

But I was having a hard time with that particular ETF and kind of getting at the answers to those things. So that's why I wrote the piece. But it's a hot area. There's, as you know, there's a new SSGA ETF. It's a partnership with Apollo that will invest meaningfully in private credit.

That's just getting off the ground. It was recently approved. And so all eyes are on that to see sort of how this experiment will play out in practice. But that has been a much talked about area. I recall back in the 1990s, a fund manager by the name of Garrett Von Wagner, who was very successful growth stock manager and started to left the company he was with, started his own group of growth stock mutual funds.

And he did this. He put private equity in a mutual fund. The problem was, there's no valuation model where you could say this is what the daily value of the value of private equity was because it's private equity. So he didn't trade. And the SEC called him out on it.

And without admitting anything, he paid the SEC something like a $600,000 fine because it was the contention of the SEC that he was mispricing these private equities in the fund. And it was an open-to-end fund. So that was a problem because that means the people who were buying the fund would be paying too much.

And the people who were selling the shares would be getting too much. So it wasn't a fair market. Do you recall that by any chance? It predates my arrival at Morningstar, but I certainly have have read about it and familiar with it. It's a pretty sort of famous example episode within the industry.

Yeah, I could see that coming around again here with what we're seeing today, but we'll see. All right. So Jeff, I mean, is there anything else that you're seeing out there? Any other area that ETFs are being created? You know, I would say the other thing that our team and our manager research team is led globally by my colleague, Laura Lutton.

One thing that they're really focused on is as categories. One is sort of in the public private realm. We're seeing quite a bit of activity in the interval fund space. And interval funds, not my cup of tea. You know, I like my managed investments to be liquid. That's not what interval funds are meant to be.

At least they're not fully liquid, like an ETF. What are interval funds? They're sort of a hybrid between an open-end fund and a closed-end fund. A closed-end fund, as I think many of your listeners might know, it's different from an open-end fund in that they don't issue new shares when demand exceeds supply.

The number of shares is fixed. And so closed-end funds, they're probably most notorious for trading away from their net asset value. There can be a premium or commonly there's discounts. And so that's one of the trade-offs that you face. They've typically been used to invest in less liquid assets and also because they can employ leverage more freely.

They've been used for income-generative types of strategies just because you can sort of gear up your yield and deliver more income to your investors. That's one of the reasons why they've attracted investors, but they're closed. Again, you can't create new shares. Interval funds are a little bit different in that they have a little bit more latitude to create additional demand and also typically in a quarterly or maybe a semi-annual interval.

They will basically tender for a certain percentage of the shares. Yeah. So it's almost like a combination between an ETF and a closed-day fund. Exactly. This has become an area where there's quite a bit of activity because it's conducive, I think, in the minds of many to investing in privately held assets, but to offer a little bit more liquidity than you would typically have if you went the usual route of directly investing in private securities or investing, say, through a private equity or a private credit fund.

A lot of private equity has a limit to the amount of redemption that can occur in any quarter and then it stops. Do these funds have that same limit? They do. They limit it and so that's what makes them more conducive to holding private assets. Yeah, but everybody runs for the door at the same time when they need liquidity.

So pensions, sovereign wealth funds, foundations, endowments who have a lot of private equity that's illiquid. What do they start selling when they need money? They start selling the public stuff and then eventually they get to the point where they've got to dump something else. It could be a fire drill here.

Everybody rushes to the door at the same time and then you can't get out. You got it. Yeah. So that's, that's definitely one of the more salient trade-offs that I think an investor in these would want to consider is, you know, you might feel pretty laid back sanguine about not needing the money right now, but when the market experiences some tumult, you might feel very, very differently.

And so may many of your co-investors in the strategy. So it's certainly something that they need to bear in mind before they plunk their money into it. The other thing with intervals is, and our team will go through and diligence these using a similar methodology at the appointed time to what we do for open-end funds and ETFs.

They can be very, very expensive and it's not uncommon for them to utilize pretty large dollops of leverage, which obviously have trade-offs associated with it. So it's the sort of thing where, you know, probably buyer beware applies and, and our team led by Laura Lutton will go through and, and they'll diligence these in the same way they do the other types of products that they evaluate, trying to make sure that they hold them to the same high standards.

You wrote a piece recently, Vanguard's Jack Bogle was right again, because what you looked at was trading, the amount of trading that goes on between ETFs and mutual funds. And you found that mutual funds, there is less trading ETFs, there is more trading, and that had certain results. Can you talk about that study?

For sure. The proxy that I was using for trading was the volatility of net flows to equity ETFs. And, and what I found by that measure is that trading in equity ETFs is about three times as volatile as trading in open-end mutual funds. And so, you know, we've long studied the relationship between investor activity and the sort of outcomes that they achieve.

And sort of the way we try to measure that is through an internal rate of return, a dollar weighted return of calculation in our power balance, it's an investor return, it's how much the average dollar does. And long story short, so I took a look at this big picture, and then more specific to Vanguard, what I found was that from a time weighted a total return standpoint, equity ETFs were earning just as much as open-end funds, in fact, a little bit more.

By time weighted, you simply mean ignoring cash flows, you're just looking at the actual return of the fund, it didn't matter how much money was coming in or going out. Exactly right. I should have clarified that. Yeah. So it's assuming a buy and hold investment. You invest a lump sum at the beginning, you hold it to the end.

And so it's agnostic to the timing and magnitude of investor cash flows along the way. And so what you found on that basis is that ETFs actually, equity ETFs, I should say, over the, I think, 10 year period I looked at ended January 2025, they were slightly out earning comparable open-end funds over that period of time, which is kind of what you would expect.

They're a little bit cheaper. However, when you looked at them on a dollar weighted basis, and so this does take into account the timing and magnitude of investor cash flows, what you found is that they were actually lagging comparable equity, open-end mutual funds. This is true for the industry at large.

It was also true for Vanguard. They weren't capturing as much of the potential buy and hold that is total return that they could have earned. Well, there's no smoking gun with these things we can't know whether that's directly attributable to over transacting. You know, circumstantially, it does lead you to conclude that some of the trading activity that we've seen in ETFs has been detrimental in the sense that their average return in equity ETFs hasn't been as high as it could have been if they had traded less, which is sort of what you see in open-end mutual funds.

And like I said, found this not only for equity ETFs and mutual funds for the industry as a whole, but also for Vanguard more specifically. The good news for Vanguard investors is the gap that I saw for ETFs between the total return of the dollar weighted return was narrower than what I saw in the ETF industry as a whole.

And even when you looked at the average dollars return in the equity ETFs that Vanguard offered, they still exceeded that. The return of the average dollar for the industry as a whole. So those are things that I think Mogul, if I could presume, would have felt good about. You know, he's a very competitive guy, wanted to beat the competition.

Vindicated. He would have felt vindicated. I can see him now, right? That's exactly what I said. Why didn't anybody listen to me? Right? Yeah, you can hear it, right? It was the reason why Jack turned down the idea of doing an S&P 500 ETF back in the mid-1990s. Great idea, but he didn't want to get involved.

He saw ETFs as pouring gasoline on a fire. One thing I would add though, to be fair to Vanguard, and it may reassure a few of your listeners, we don't typically publish gap data between dollar weighted returns and total returns for particular fund families. But when I've studied this just on my own time, what I have found is that the gap for Vanguard funds and ETFs has been meaningfully narrower.

And so what that means is that Vanguard fund investors are earning more of their funds' total returns. A different way, I suppose, to put that is they're doing a better job of timing their cash flows or just being disciplined than we're seeing elsewhere in the industry. And so that's to their credit.

Talking about cash flows, we've got 1,300 mutual funds created, 1,700 ETFs created in the last three years, although there's been a lot of mutual funds that have closed, a lot less ETFs that have closed. We've got all these funds, but where is the big money going? Okay, so I'll run through them, sort of the broad categories.

So it's going to indexing, it's going to ETFs, and it's going to Vanguard and BlackRock primarily. They're hoovering up cash at an almost historic rate. And we can get into the specifics here, but maybe I'll focus on the trailing year ended February. So with respect to ETFs, they saw $1.2 trillion in net inflows.

And so I think for the year 2024 was the biggest ever for ETFs, 1.1 trillion of net inflows. And so that's equivalent to a 14% organic growth rate. Well, this is inflows. This is not gain in the market. This is actual new cash coming in. That's correct. Exactly. So again, that was $1.1 trillion of net inflows last year, which was equivalent to around 14% of what would have been the beginning net assets in the US ETF industry at the start of that year.

And contrast that with open end funds. Last year, they shrank by around 2% of their beginning net assets. So it was around half a trillion dollars in outflows, give or take over the course of last year for open end funds. So you've really seen a sea change. And this is just the past year that trend has been playing itself out.

The ETF industry at this point, for those who are wondering, it's a nearly $11 trillion industry. Open end funds, believe it or not, despite the fact that we've seen this torrent of flows out of open end funds into ETFs, it's still a $21 trillion industry. So when you look at the market share of open end funds versus ETFs, it's still about two to one open end fund assets to ETF assets.

Open end funds still have about two thirds of the market compared to the ETFs, one third. I mentioned index versus active being the other line of differentiation, kind of how it cleaves. As I mentioned, index is dominating. So if you're to focus on the year ended February, $918 billion of net inflows into index funds, and that's what's going to be the other year.

It's going to be the other year that's going to be the other year. Wow. 2024 was the second biggest year for index funds on record. It was a very, very historic year when it came to ETFs and index funds more generally gathering assets from investors. You know, sort of the more popular categories for discretionary active ETFs, in case you were wondering about that, were ultra short bond, large blend, derivative income, which is sort of like, you can think of that as sort of covered call, sort of option writing strategies, core plus bond in large value.

That's where we've seen sort of the active ETFs come to the fore. We've seen more launches in that area in the past few years than we have for some others. But have they gathered assets? Are they just launching these things with the hope of stopping the flow out of their actively managed mutual funds?

We may be cannibalizing our own open end funds, but at least we'll be stopping the flow going to somewhere else. So I mean, are these things attracting meaningful assets? Yeah, that's a great question. The short answer is they are. So 2024 was a banner year for active ETFs. They saw around $290 billion in inflows, according to our estimate.

Wow. Over the past three years, they saw around $560 billion of inflows, which is equivalent to around 24% of all flows that we saw to ETFs. And so like the biggest ones that you would see are the bestsellers. So there's a Janice Henderson, AAA CLO ETF, which I think has seen around $15 billion in flows over the last three years.

I think I mentioned JEPI, which is the JP Morgan equity premium income ETF. There's a NASDAQ version, which has been a hot seller. And then Fidelity has an active bond product, Fidelity total bond ETF, which has also been hot selling as well. You know, this has definitely been an area of real interest and activity for the providers, as you can imagine, and it's paid off by some measures.

So let's get into the active versus passive. We chart comparisons. And by passive, I'd like to stick with Jack Bogle's view of a traditional index fund versus a, what I call a Spindex, which is a special purpose index fund. And call it a, you know, a NVIDIA 2X. You've done a lot of work.

Morningstar has always done a lot of work, as have other companies on active versus passive. You just recently have come out with your annual report looking at 2024 and previous to that going back many, many years. What's going on? Are these newfangled ideas that are coming out in ETF format?

Are they outperforming? What is going on in the active versus passive debate? Yeah, great question. So we did put out a report recently. We call it the active passive barometer. My colleagues, Brian Armour, Ryan Jackson, Eugene Gorbatikov, and Human Kim put it out. And it looks at active fund success rates versus a style-appropriate passive composite over different trailing periods.

To answer your question, Rick, we're seeing far more failure than we are success, especially as you look at the longer period. So just to give you an example for the U.S. large cap categories, only about 6% of active U.S. large blend funds beat their passive composite composite over the 10-year period and to December 2024.

For large value, it was around 14%. And for large growth, it was only 3%. And so those are very, very sobering figures indeed. As you range out to some of the other areas, you would have seen the success rates perk up a bit. For instance, as you move towards small cap, you're talking about 20% to 30% of active small cap funds that started the period survive to the end and beat their passive composite.

But that's still less than a coin flips chance. Where you do see the success rates get meaningfully better, at least in relative terms, is within active bond funds. And so as you move to areas like intermediate corporate bonds, high yield bonds, that's where the success rates can approach 50%.

But again, in a number of these cases, you're talking about a coin flips chance for many investors, they'll conclude that's not good enough odds, and they'll opt to index, which I think for many investors is advisable anyway. But it's an excellent report my colleagues put out. It is. You do a great job with this.

It's hard to categorize some of these funds, but I mean, you do the best that you can do. I would like to point out a couple of things. As you go further out, I mean, time is not on your side, right? I mean, over a one year period, it might be some years 60% of active outperformed, some years 40, some years less.

But as you move out to five years, the number drops. You also have a survivorship bias. I mean, a lot of funds just close, and so they're not included in the data anymore. And the only data you can include is the funds that's still around, and maybe the funds that were around before they closed, you can include that data.

But once you go out to 10 years, the percentages drop even more. 15 years, they tend to drop more. And by 20 years, you're really, really dropping. And I found this to be true, regardless of the period of time you're looking at. It could be the last 20 years.

You could start in 2000, looking backwards 20 years. You could start in 1980, look backwards 20 years. And these numbers are very consistent. The longer you hold your active funds, the lower the probability they will outperform the index. And you talk about that phenomenon, that recurring phenomenon. Oh yeah, for sure.

No, I think that point's really well taken. I would say the common denominator across all these different time periods that we might have measured, you know, going back in time, funds come and they go. My colleague found that, you know, over a typical 10-year time horizon, 30 to 40, in some cases, even 50% of the active funds that began the period did not survive to the end of the period.

And so, the common thread here is sort of the perishability of some of these active funds. That plays a large part in explaining why success rates aren't higher than they are. I'm not suggesting that they would necessarily be markedly better, even if all of these active funds that die in droves were to somehow survive to the end.

There's a number of other factors that probably portend against that. But nevertheless, one of the overarching factors in why active funds have struggled to beat their passive composites in greater numbers is the fact that they just don't make it to the end. They don't have the staying power. The other thing I wanted to bring up about the data is that you mentioned in the last 10 years bond funds, if you bought an actively managed bond fund, it's maybe a coin flip.

You've got a 50-50 chance of outperforming the bond index. However, I do want to point this out about the difference between bond funds and stock funds, is that when you look at the range of returns of the stock stock funds over that 10-year period, it's an 80 percentile of the funds fall into a very wide range, like 5% between the ones that do come close to beating the market or even maybe beat it by a little bit, and the ones on the other side of the chart that underperform that 80 percentile.

It's a wide range, like 5% difference. But that's not the case with bond funds. Bond funds is a very narrow, peaky graph, where the ones that outperform might outperform by a half a percent. The ones that underperform, underperform by maybe a half a percent. And if you just bought the index, which is in the middle, you did just fine.

So if you're going to try to beat the market, and you want to beat it meaningfully, and you're trying to do it in a balanced portfolio, it becomes very difficult because the equity side of that has a very low probability of outperforming. And you could underperform by an awful lot.

So if you have a three-fund portfolio of U.S. stock, international stock, and bonds, you could pick three actively managed funds. The bonds might actually do okay. They might outperform by a half. But if one of your stock funds underperforms by three percent, I mean, you just blew the whole thing out of the water, and you should have just had three index funds.

No, I think that's exactly right. If we look at this on two different axes, one being likelihood of success, the other being expected payoff, I suppose. Like you say, what you would find is that you probably have a lower likelihood of success in equity, albeit with maybe a larger potential payoff, should it survive to the end and actually beat the passive composite, should it do so.

Whereas with fixed income funds, there might be a slightly higher chance to succeed to beat the passive composite. But as you say, it's not going to do a moonshot. You're not going to get this huge payoff where it's beating the benchmark by multiple percentage points. If it's doing so, you actually probably want to diligence further just to make sure you understand your strategy and why there's that sort of tracking error to it, because it can obviously go the opposite way.

So you should be thinking of it along both of those dimensions, as you rightly point out. I wrote about this in a book called The Power of Passive Investing, and I said the same thing. It's like, you might be able to pick one fund out of three that outperforms, but unless that outperforms by a lot, your portfolio still underperforms.

So just do all index funds, and you have a high probability of outperforming a portfolio of active funds. I do want to get to a couple more items. And you did a lot of work on active funds again, but here looking beyond the fee. Clearly, everyone agrees that active funds have higher fees, and you have to get over that hurdle rate first.

But your research even went in a little bit deeper, at least recently, that says, well, you know, if you buy the past performing funds that have low fees, something might be there. Can you describe that? Yeah, so we took a look at what might be doing a good job of sorting based on future performance, as it were.

And so we looked at a couple things. One was past performance before fees. The other was fees themselves. And what we actually found is that if you favor the funds that had the best past performance before fees, and then furthermore, within that cohort, you favor the lowest cost, you greatly boosted your odds of success of beating your average peer over time.

So I think for a lot of your listeners, they're already sort of well accustomed to sort of pinching pennies and favoring lower cost funds. I think that probably they would be less inclined to factor past performance in. But what our research found is that actually past performance before fees has done a more than respectable job in recent years of sorting funds based on past performers.

Those which outperform before fees, this was across asset classes and across years, were likely to outperform their average peer going forward than were the low performers in the past which tended to lag their average peer peer over future periods. So the message is that if you are going to pick a active fund, let's say you're in a 401k plan and they don't have any index funds, which would be very unusual, by the way, because most 401k plans at least have an S&P 500 now.

But let's say you're in a 401k or 403b, you know, legacy thing that's really not good investment options. Then you should opt for the highest past performing active fund that has the lowest fee and that gives you the highest probability of at least getting maybe close to the market return, if not maybe outperforming.

I would start with fees. I think that's your best starting place. And my colleague Russ Kinnell did landmark research some years ago on which variables do the best job of predicting future fund net return performance and fees shine through. And so if anything, I think the research that I did more recently builds very slightly on the work that Russ had done previously.

But fees not only tilt the odds in your favor if you're looking at it versus other funds that are relevant peers, but also some of the more recent research I did, you know, I found that cheaper funds are likelier to survive over a longer time period than our pricier funds.

So you also tilt the odds in your favor that way. Then secondarily, you can look at performance, you know, we have tended to find in the last, you know, 10, 20 years, that past performance before fees has done a pretty good job of sorting. But I would start with fees.

I think that that's the most reliable starting point. And certainly Russ found that some years ago. I think I'd just make one last comment on past performance. It's been a momentum market in the last few years where the magnificent seven, you had to have them. And it's been that way for several years.

And active managers who did have them probably kept them at least a portion. In fact, you had an article on that talking about the portfolio construction of active funds, where they look a whole lot more like closet index funds than what the active managers would say. But the bottom line is there's been a lot of momentum in the market.

Does some of that research about past performance have to do with recent momentum? Yeah, I think that's very astute. So I, I owe sort of our readers a follow up article to sort of dig into what some of the factors that explain it. But, but I think that you're keying on on some of the most important factors.

We've seen an unusual persistence of large beating small of growth, beating value of domestic, beating foreign, of spread within fixed in, beating govy. These are areas which, in some cases, you'll see the best past performance having had favored, and they'll stick with that. And it's tended to reward them if they've stuck with those things.

So yeah, there has been a certain pro cyclicality to it. And I think that explains some of the trended performance. But as we know, that can reverse itself quite dramatically in the markets. And so that's why I think, I think probably people are best served to start with cost rather than past performance.

Last area I want to get into is portfolio management. And just a couple of items here. Sure. A couple of reports that you did looking at the asset allocation of portfolios. And we tend to, I don't want to say we're trend followers. We, we are, but the fact is we are trend followers, at least to the point where we don't like to rebalance.

And that when U.S. equities are doing well, we tend to let that become a greater and greater portion of our portfolio than rebalancing, say, to international. Or if equities in general are doing better than bonds, or bonds are not doing well, so you really should be selling some stock and buying some more bonds, we tend to not do that.

At least that's what I read from your data. Is that an accurate assessment? That is an accurate assessment. Inertia is very powerful. And on the flip side, it can be very uncomfortable. Indeed, when we go through a rebalance take from our strong performers and give to our weak performers, there's a natural aversion to doing so.

It's incidentally, it's one of the reasons why I think that strategies which automate those tasks, like target date funds, like target risk funds, are so useful to investors. Certainly, there's probably an optimal solution out there, quote, unquote, that could maybe carve the asset allocation more precisely, or do the rebalancing and reconstitution in a more tailor made way.

But I don't think people should make perfect the enemy of good target date funds, target risk funds, are perfectly acceptable solutions. They help people to earn more of their funds, total returns to participate in markets, and to do so in a way that appropriately balances risk and opportunity. And so I think that helps you to overcome inertia, and there's no real action that's required on your part.

But the research that we did recently, you know, in a sense, it tried to quantify some of that inertia. And what we did was we just went through and we tallied up all the assets by type of fund, and literally the securities that they held. And what we found that there was some drift into equities, US equities, large in particular, and away from some of the areas that haven't performed us strongly.

So cash bonds, foreign stocks. And so, you know, when you kind of went through and sort of added it up, it was around we found $800 billion in assets that probably ought to be rebalanced, assuming certain things about what kind of the baseline allocation should be. It's not huge in percentage terms.

I think we're talking about 3% of the equity allocation would need to be moved back into cash and bonds, let's say, and then within the equity sleeve a little bit of rejiggering around of the domestic to foreign split. You know, but it's real money in dollar terms. And we've seen in periods like the one we're coming off of that we can all get a little complacent as investors in doing some rebalancing and adjusting given our objectives and circumstances can be very much worthwhile.

And this was our attempt to quantify that. One last question. We're talking about the creation of ETFs and target date funds. I still am yet to see any kind of a push by the fund companies to create balanced ETFs, very low cost, balanced ETFs that do, let's say, a life strategy fund at Vanguard.

In fact, Vanguard hasn't even created a life strategy ETF yet that we could use, say, in an IRA. Why is that? Do you have any idea? David Stein: So I think that probably just one practical operational reason is that target date funds, they've been used most often within the context of a 401k plan.

The 401k plans, their pipes and plumbing aren't set up to hold ETFs. And so I suppose from that standpoint, if they're just to look at it as capitalists, they would conclude it's not worth their while to develop these because they can't put them in the place where they enjoy the most uptake.

But I completely agree with you that from just from an overall investment utility standpoint, they make a great deal of sense. David Stein: You know, particularly, you know, maybe they would need to get a little bit creative on the fixed income side. But if you think of taxable money, we know that equity ETFs, you know, they excel in keeping cap gains distributions to a minimum.

In theory, you could deploy some of the fixed income sleeve into things like munis. Maybe they don't scale quite as well, but that would be a nice solution for taxable investors. In particular, I would warmly welcome target date and target risk ETFs. Because like you said, I think they've got lots to offer investors.

Simplicity is the key. And so as people move into ETFs, being able to offer them simpler, more ready made options like target date, target risk ETFs, I think that would make a great deal of sense. David Stein: Index ETFs, meaning, you know, very, very low cost, few basis points.

David Stein: Right. Well, Jeff, it's been wonderful having you back on Bogleheads on Investing. Thanks for all that great information. And hopefully, we'll see you again sometime. David Stein: Thanks again, Rick. It was a real pleasure. David Stein: This concludes this episode of Bogleheads on Investing. Join us each month as we interview a new guest on a new topic.

In the meantime, visit Boglecenter.net, Bogleheads.org, The Bogleheads Wiki, Bogleheads Twitter, The Bogleheads YouTube channel, Bogleheads Facebook, Bogleheads Reddit. Join one of your local Bogleheads chapters and get others to join. Thanks for listening. David Stein: Thank you.