Active investment managers are in for more pain as investors stung by underperformance will continue to move assets into low-cost index funds, Moody’s Investors Service said.

“The shift toward passive investing is not temporary, and flows could accelerate,” Moody’s said in a report issued Monday. “Over time, active management will likely have to shrink substantially.”

Stock- and bond-picking firms should re-emphasize performance over growth and marketing while also reducing costs and assets under management, the ratings company said. The decision by some firms to acquire competitors or alternative asset managers won’t help since that doesn’t address the causes of underperformance.

For the past decade, investors have been flocking to low-cost passive funds and dumping active managers that failed to beat markets. Peter Kraus, the chief executive officer of AllianceBernstein Holding LP, estimated last month that assets in actively managed funds may have to shrink by as much as 30 percent to restore their ability to beat indexes. BlackRock Inc. CEO Laurence D. Fink predicted consolidation in the business.

Too Many Funds

For the five years ending December, 39 percent of actively managed equity mutual funds beat their benchmark indexes, according to Morningstar. In the past two calendar years, three-quarters of taxable bond funds trailed the market averages.

The proliferation of funds is one cause for lackluster returns, Moody’s said. There are more than 9,250 mutual funds and 10,000 hedge funds compared with 3,691 stocks in the Wilshire 5000 and 505 stocks in the S&P 500.

“Overcapacity leads to investment mediocrity, since true talent is limited and size works against the investor in the form of increased transaction costs and difficulty in identifying scalable investment opportunities,” according to the report written by analysts including Stephen Tu and senior credit officer Robert Callagy.

Moody’s expects further ratings deterioration for large traditional asset managers that "lack core competency in passive investing, or that are unable to deliver outperformance to justify their fees."

Some managers have already received downgrades or changes in ratings outlook, including Legg Mason Inc., Waddell & Reed Financial Inc. and Gabelli. Moody’s says that recent ratings and outlook changes reflect concern about the future of traditional active management.