Vanguard, the world’s largest mutual fund company with more than $4 trillion in assets under management, had a smashing 2016. It was the top destination for investors, raking in net inflows of more than $277 billion that crushed its competition, according to a Morningstar report that tracks U.S. mutual fund and exchange-traded fund asset flows.

Investors also validated Vanguard’s core belief in index funds, injecting a record $505 billion into all passive funds — with half going to the company, the report said. Meanwhile, the typically costlier actively managed funds saw an exodus of $340 billion overall, widening the gap between active and passive funds.

Are actively managed funds — those led by managers who choose where to invest — on the way out? Vanguard CEO Bill McNabb does not think so. “The death of active may be overstated,” he said during a keynote speech at Wharton’s annual Rodney L. White Center for Financial Research Conference on Financial Decisions and Asset Markets. But he does see major shifts in the industry that call for a new way to do business. “The change in the economics of the investment management business is pretty profound.”

The numbers tell a grim story: From 2007 to 2016, the number of actively managed U.S. equity or stock funds fell to 2,223 from 4,351 — a survival rate of 51%. And a whopping 80% of active funds underperformed their market benchmark in the same period. Actively managed U.S. fixed income funds, those investing in bonds and other debt, also did similarly dismally. “This is not a positive thing for the industry,” McNabb said. “I view it as experimenting with other people’s money in many cases, which I don’t think is the right way to run a business.”

Even actively managed funds that do well tend to turn in uneven performances. McNabb noted that of 275 successful funds whose performances were tracked between 1998 and 2012, 97% of them underperform in at least five years in a 10-year stretch. Making matters worse is that tracked returns are generally better than what ordinary investors actually make in their portfolios.

“The death of active [investing] may be overstated.”–Bill McNabb

Funds’ returns assume the money stays put. In practice, people who cannot stomach market volatility tend to move out of the fund too soon and move back too late, or sell low and buy high. Citing Morningstar figures, McNabb said investors’ actual returns are 1.5% to 2% lower than the fund’s posted performance.

The Shift to Passive Investing

McNabb traced the start of the major shift from active to passive  — funds that invest in an index such as the S&P 500, for example — to the dot-com bust of 2000 to 2002. In the years before the market collapsed, investors found it easy to make money if they invested heavily in tech stocks. “If you’re overweight in tech, you’re a hero,” he said. Growth managers loaded up on expensive dot-com stocks, betting on fast-rising startups, while value managers, whose job is to look for bargains with potential, forgot their core values and jumped into the expensive tech sector as well.

The result was a “trainwreck” as the dot-com boom turned into a bust, McNabb said. “Investors were really disappointed. People thought that by having an actual manager [manage their funds] they would do a little better. They actually did worse in most cases.” This experience not only changed investors’ attitudes, he believed, but also altered the way advice was given to ordinary investors. Financial advisers, who typically charge commissions, are shifting their compensation to a fee based on the percentage of assets. In 2000, 15% of advisers used asset-based compensation. Today, nearly 70% of them do it, McNabb said.

What also changed was the realization by the industry that fund costs are important when it comes to maximizing an investor’s returns. “Total costs became much more important in their value proposition to their clients,” McNabb said.

The industry saw the power of asset allocation over stock picking as well. How an investor divides funds into different investment buckets accounts for 85% to 90% of performance. Brokers used to give their clients a list of the best stocks or funds to put their money in, but the ability of money managers overall to pick securities was not consistently great, he said. “It began to be apparent to them that was a losing proposition to the client.”

Financial advisers began to pivot toward creating a portfolio for clients that followed an asset allocation model that was well balanced, diversified and fits their long-term goals, McNabb said. They also steered people towards low-cost funds to enhance client returns. He said funds with expense ratios, or annual fees, in the lowest quartile attracted $611 billion over the last 15 years while those in the top three highest quartiles lost $549 billion.

Advisers’ emphasis on asset allocation and low-cost funds “has been more the driver to indexing” than any academic research or marketing by Vanguard, he said. “I’ve never seen a marketplace move as quickly as this in my lifetime.” Not even the father of index funds, Vanguard founder Jack Bogle, had that kind of clout.

Robo and Personal Adviser Hybrid

But active management must change the way it does business if it wants to thrive, and McNabb offers a playbook. (Vanguard is known for its index funds but it also has actively managed funds.) Over 10 years, around 90% of Vanguard’s active fixed income funds and 83% of active equity funds have beaten their peers. “The reason for that has a lot to do with cost,” McNabb said. “Our active managers start out with large cost advantages.”

Vanguard’s analysis shows that the performance of traditional active equity funds is equally due to cost and the manager’s skill. Vanguard’s expense ratio is 0.37% for its average active equity fund, compared with 1.11% for the industry. In its active fixed income funds, Vanguard charges 0.17% to the industry’s 0.81%. “If you’re going to describe a playbook on the active side going forward, I think [low cost] is going to be part of the playbook,” McNabb said.

In particular, McNabb sees advisory fees falling. “I don’t think it’s going to be possible for advisers to keep an 80, 100, 120 basis point fee for providing investment advice going forward,” he said. Exacerbating matters is that finding good returns is also harder today due to the “professionalization” of the market, he added.

“If you’re going to describe a playbook on the active side going forward, I think [low cost] is going to be part of the playbook.”–Bill McNabb

McNabb pointed out that in 1963, there were 284 chartered financial analyst (CFA) candidates and more than 80% of investor funds were not professionally managed. Today, there are nearly 178,000 CFAs and 68% of investor funds are in professional hands. That means there are more experts looking for investment opportunities, making it harder for anyone to gain an edge.

In 2015, Vanguard began offering low-cost financial advice to retail, or ordinary, investors through Vanguard Personal Advisor Services. It charges 0.3% of assets, which McNabb said was possible after combining advice dispersed by humans with “robo-advisors,” algorithms that tell investors how to allocate their money depending on their target return, risk tolerance and other factors. The advisory service has attracted $70 billion in assets.

McNabb sees low cost as the wave of the future. “The average retail investor will be paying less on product and advice in a low interest rate environment — that’s actually going to be powerful and important going forward.” The down side is it will be “disruptive for providers and people who don’t see it coming or don’t take it into account in their strategic thinking.”

McNabb expects investors to continue to move into index funds — and there is still plenty of room in this market for passive to grow. He pointed out that index funds comprise just 13% of U.S. equity funds and 4% of U.S. fixed income funds. Globally, the figures are 15% and 5% of trading volume, respectively.

However, one conference participant questioned the wisdom of having much more money going into index funds. “If there’s too much indexing you can imagine the market becoming inefficient” because the research and resources underlying active investing will diminish, thereby reducing the assimilation of information into securities prices. Though a legitimate concern, the fact that active currently represents 85% to 87% of all funds indicates the markets are nowhere near the tipping point.

Financial Institutions, QE and Dodd-Frank

Following McNabb’s speech, a distinguished panel of academics and practitioners convened for a round table discussion on the financial markets and institutions post-financial crisis. The panel included McNabb, Nobel Laureate Tom Sargent (professor at the NYU Stern School of Business), Doug Diamond (professor at the University of Chicago Booth School of Business) and Tony Santomero (member of Citi’s board of directors, past president of the Philadelphia Federal Reserve and emeritus Wharton faculty). Scott Richard, Wharton practice professor of finance, moderated. (Except for McNabb, they requested no attribution for their published comments.)

On a macro level, the panel said, the market has changed since the financial crisis. The Federal Reserve has bought up troubled mortgage securities and pumped money into the system in bouts of quantitative easing (QE), which is largely uncharted territory.

Before 2008, there was an interest rate target entrusted to open market operations by the trading desk at the New York Federal Reserve Bank, which retained “full control of the quantity or monetary base” to make the transactions, one panelist said. The Fed manipulated quantity to control prices.

“What will happen if banks and the public lost confidence in the central bank’s ability to keep inflation under control … ? With the tools the Fed has right now, there will be a lot of inflation.” –Conference Panelist

After QE, “the monetary base is many times what it has been, so there’s space for huge excess returns,” he continued. As a result of the crisis, the Fed “acquired a vast new tool — setting interest rates on reserves. That’s a fiscal tool.” The idea was that interest rates on reserves will “act as a floor on the interest rate on the interbank market so in the best case scenario, this excess monetary base is not needed but kept at the central bank.”

However, such actions have “monetary implications,” the panelist added. “What will happen if banks and the public lost confidence in the central bank’s ability to keep inflation under control and started to use those reserves, and cash in those reserves? With the tools the Fed has right now, there will be a lot of inflation. There will be a run to big inflation.

“Is this far-fetched? I don’t think so,” he continued, pointing to the 1920s German hyperinflationary period in which Germany’s central bank printed money not only to finance expenditures — this was a small part of it — but was “paying interest rates at a very low level.” He based his comments on the findings of the research paper, “Speculative Runs on Interest Rate Pegs.”

But another participant on the panel pointed out that the Fed’s holdings are offset by positions in bonds, and returns are given to the U.S. Treasury. “It’s a tricky process,” he conceded. “I’m not sure how that washes out. … Banks are putting their money into the central bank, the central bank is financing its long-term bond positions and the profit is reverting back as part of the Treasury’s budget.” But he wished the Fed would divest of these securities more quickly, down to $1 trillion from the current $3.5 trillion. “At the moment, no one seems to want to worry about it.”

Another impact of the distortion of the capital markets is that investors, whether sophisticated or not, “moved up the yield curve and up the risk spectrum” in an environment of zero interest rates on money market funds as they chased higher returns, one panelist said. “If you look at high yield bonds, they are probably the most overvalued I’ve seen in 10 years. … [Investors] have taken in more risk than they really understand.”

The government’s attempt at normalizing the markets included creating more regulations to prevent future crises. The fiduciary rule, which the Trump administration is reviewing to possibly rescind, would require financial advisers to have their clients’ best interest at heart when recommending investments, taking into account the level of commissions they have to pay. Without the fiduciary rule, advisers can put clients into higher-commission investments as long as they are roughly appropriate to their needs.

“We now have an industry that used to run itself but now is run by a set of rules imposed upon it by regulators … These are extraordinary things.”–Conference Panelist

McNabb said this rule “should survive” even though some of its stipulations could be improved. “Net net, I think it’s a good thing for the industry. I hope it doesn’t get rolled back. The spirit of the rule is correct.” But one change he would like to see is a “harmonization” of the definition of fiduciary duty, which is different for two regulators: the Securities and Exchange Commission and the Financial Industry Regulatory Authority.

As for the Dodd-Frank act, put in place after the financial crisis to beef up stability, McNabb said it added 700 new rules with which Vanguard has had to comply. “We’re only halfway through implementation.” However, he believes that its stipulation to increase a bank’s capital “is not a bad thing. I think it made the system safer.” As for the Financial Stability Oversight Council, or FSOC, which was established by Dodd-Frank to identify and monitor financial systemic risks, McNabb would like to see it have “somebody to whom it is accountable.”

Another panelist commented that “overall, I like Dodd-Frank.” If the question is whether to keep it or repeal it, he would keep it. However, he is not a fan of the Volcker rule, part of Dodd-Frank and named after former Fed chairman Paul Volcker. It would restrict banks from making certain speculative investments and engaging in some types of proprietary trading. Instead of this rule, “capital requirements are a much better way to go.”

However, there is a danger of regulatory overreach. “The market’s much more vulnerable than it was before. Part of this is the grand overstatement that ‘we’re going to eliminate too big to fails.’ Next time we have a financial crisis, the government will do nothing but will allow everyone to collapse,” a panelist said.

“We now have an industry that used to run itself but now is run by a set of rules imposed upon it by regulators — everything from can they pay a dividend and how much, what is the structure of their asset portfolio, what is the structure of their liability portfolio, what are the kinds of assets they can put on their balance sheet,” he continued. “These are extraordinary things.”

“Do we need safe institutions? To be sure. Do we need more capital from where we started? To be sure,” he added. “How you revert that to a private sector industry that is subject to oversight from what is now a private sector industry that is directed by Washington is a very complex problem and one that neither the right or the left has articulated an appropriate strategy for. I think the solution is somewhere in between.”