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Fiduciary Rule Could Spur Passive Fund Demand

Changes in the standards to which financial advisers must adhere will likely support an ongoing trend of adoption for lower-cost passive mutual funds and exchange traded funds, according to S&P Global Market Intelligence.

According to data from Morningstar, passive long-term funds gathered $413 billion of fresh money in 2015, while active ones bled $207 billion of assets. The gap between active products ($9.4 trillion) and passive products ($4.5 trillion) will likely further contract following implementation of a new Department of Labor rule, according to S&P Global Market Intelligence.

Under the Department of Labor's fiduciary rule, financial advisers providing investment advice for retirement accounts will now be subject to a fiduciary standard rather than the suitability standard. Previously, an adviser needed to have a reasonable basis to believe that a recommended transaction is suitable for the customer. Now, the adviser and their company are required to act with the care and diligence that a prudent person would exercise based on the current circumstances.

225 of these share classes (27% of the large-cap core universe) have an expense ratio higher than 1.35%, making them expensive in our opinion.
The average net expense ratio for large-cap core mutual funds is 1.1%, according to data from Thomson Reuters Lipper, which is much higher than the 0.05% for Vanguard 500 Index Fund (VFIAX). But 225 of these share classes (27% of the large-cap core universe) have an expense ratio higher than 1.35%, making them expensive in our opinion.

During the five-year period ended April 5, the large-cap core peer group (which primarily includes active, not passive, mutual funds) generated an average annualized total return of 9.4%. This is much lower than the 11.3% gain for the passively managed VFIAX. Moreover, 80 of the "expensive" funds were in the bottom quartile during this period. High-cost mutual funds with poor performance records will be harder for a financial adviser to justify, in our opinion.

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As advisers shift to a fee-based approach to building client portfolios, there are more low-cost choices to consider across various investment styles. For example, according to S&P Global Market Intelligence research, there are 14 mid-cap core ETFs, offered by 10 asset managers. iShares Core S&P Mid-Cap ETF (IJH), Schwab US Mid-Cap (SCHM) and Vanguard Mid-Cap ETF (VO) all have an expense ratio of 0.12% or lower. But the exposures they provide are different.

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