An excessive use of passive funds could deprive companies of investment, take focus away from corporate governance and leave investors under-diversified, according to Royal London.
The popularity of passive funds has steadily increased in the past 15 years. Competition between individual passive funds drove down their fees, making them even more attractive for investors.
Passive funds in 2017 made up almost half of all assets under management in the UK, up from a negligible share at the beginning of millennium.
Royal London Asset Management chief investment officer Piers Hillier says: “There has been a flood of money into passive funds in the last decade as active managers have struggled to demonstrate that their higher charges deliver consistent value for money, and there is no doubt that passive investment forms a valuable part of any investment mix.
“But there would be dangers both to individuals and to the economy if the benefits of active management were to be lost completely and the dash for passive investment continued unabated. “
Royal London analysed what could happen if passive funds’ uphill trend continues. In a paper released today entitled “Could the passive investing pendulum swing too far?” the researchers lay out possible risks to individuals and the economy if passive investing were to become completely dominant.
The policy paper envisions a world, where most funds, or all of them, are passive.
Switching to all-passives would lower diversification, the paper warns, breaking with investment tradition of “not putting all eggs in one basket”.
The paper also notes that investors in passive funds often can’t opt out of owning a particular company, even if it delivers a profit warning or disappointing earning calls.
In passive funds, investors could be stuck with disappointing shares for longer. When it comes to under-performing companies, active funds managers who can sell poorly performing shares may beat passive funds, the paper argues.
Royal London also fears that the dominance of passive funds could deprive growth companies of funding.
The authors of the research describe the role of active managers in IPOs in allocating capital and setting the price. Growth companies could miss out on funding without them, because of this, according to the paper.
The paper states: ”New businesses looking to raise start-up funding would find it more difficult if most investment flows were restricted to established companies covered by share indices.”
Royal London also foresees less interest in researching companies’ corporate governance, as passive managers could see it as an excessive cost.
Businesses could therefore enjoy less accountability, knowing that their shares won’t be sold in an active trading if they make questionable decisions.
Hillier says: “More worrying still, without active managers holding their feet to the fire, the managers of British industry would face less challenge and may fail to maximise the potential of their businesses.”
”Whilst the research endorses the use of passive funds and supports the view that the onus is on active managers to demonstrate that higher costs are delivering value, it also warns about the risks if passive investing were to be totally dominant.”