Experts have questioned whether passive investing could eventually dominate over active, as reports warn of big fund houses quickly expanding their foothold in global indices.
Bank of America Merrill Lynch recently flagged that active managers could be faced with a potential “ETF-ization” of the S&P 500 as US giant Vanguard doubled its stake in the index since 2010.
Vanguard, which is the world’s second biggest asset manager after BlackRock with £4.5trn under management, currently owns 6.8 per cent of the US index and has more than a 5 per cent stake in 491 of its constituents.
In its report, the US bank also warned managers Japan-focused active funds have taken a hit as passives take over the market. Passives now account for 70 per cent of assets under management held in Japan equity funds, the report says.
But could passives really overtake the market share of active funds? What is the picture in the UK and how should active managers react?
Carving up the cake
Lipper head of EMEA research Detlef Glow says passive funds such as ETFs are “far away” from beating mutual funds’ market share, but says it’s no surprise the top group for fund inflows over 2016 was BlackRock (£35bn), which offers more than 800 ETFs globally as well as other passive funds, largely powered its iShares business.
In Europe, index trackers and ETFs each have a 6 per cent market share by assets under management with around £580bn and £627bn respectively, according to Lipper.
However, actively managed funds still dominate with nearly £9trn assets or 88 per cent of the market share.
Glow says: “ETFs have been around for 16 years and despite their market share being the same as index trackers, they are going to overtake index trackers in a few years.”
Commentators have discussed what could be an ideal ratio of active to passive funds to have a well-functioning financial market.
As of June, 84 per cent of the funds available to UK investors are active, with 16 per cent passive, according to Morningstar data. In 2007, the ratio was 92 per cent active funds versus 8 per cent passive.
Former Investment Association chief Daniel Godfrey, now co-founder of The People’s Trust, says as a 100 per cent passive market would not be viable, active management needs reforming.
“Although I think passive is better than most of the active industry I would rather see 100,000 partnerships running £1bn each and no passive because if you are running 30 stocks [it means] you care about those companies,” Godfrey says. “When firms say they are underweight or overweight an asset or stock…I’ve never understood why we are paying fund managers to buy shares hoping they will do badly. Asset management could change its models but that doesn’t happen overnight.”
Ranking by returns
Seneca Investment Managers chief investment officer Peter Elston says fund managers who use passives to reduce costs and attract investors are taking the wrong path.
He says: “The right response is to focus on returns. Show how active you are and increase your potential for alpha generation. The tracking error [measure] is a rough rule of alpha. If it is too low you can’t produce any alpha.”
Godfrey says the rise of passive is “absolutely understandable” given the short-termism of many active managers, who are uniquely focused on beating index benchmarks.
He says: “Index funds are the right answer to what I think is the wrong question, which is: how do you optimise your chance of achieving at least the index return? The industry’s obvious answer is to buy a passive fund. But that is not what we need for our money. What we need is to optimise our long-term returns.”
Godfrey warns investors who opt for automated investment firms which only use passive funds might not be better off in terms of long-term value.
He says: “I have some concerns on the disruption coming from robo-advice putting people into passives only. An index is nothing more than a moment-by-moment representation of the short-term share price of every component of it, so it is the perfect focus on short term. And this is the enemy of long-term value.”
Experts’ views on how much of the S&P is held in passives vary, with many saying this could range from 50 to 80 per cent. Morningstar estimates this figure is as low as 35 per cent.
However, director of passive fund research for Europe Hortense Bioy says it would be difficult to see how much of a UK index is held in passives because of different reporting requirements compared to the US.
She says: “We want to have a well-functioning capital market. In the US, it has been one directional market since the financial crisis. Sometimes drawdown can be bigger for passive funds and in a downturn investors like the comfort of active funds.”
However recent figures from Lipper tracking the European market show most people sold out of mutual funds and bought into ETFs in times of crisis. In 2008 and 2011, ETFs in Europe took solid inflows at the expense of mutual funds, which lost more than £700bn in the two periods combined.
Smart beta distortions
However, Bioy argues there are ways for active funds to boost distribution and compete against passives.
She says: “There might be more money in passives than active in the US but in Europe this is not the case. With RDR and MifidII we will see fees coming down and as distribution channels open up and passives will grow too.”
Bioy adds that while active management is often accused of short termism, price distortions could also mean a manager might hold stocks for longer.
She says: “We don’t know yet how the rise of ETFs is changing prices for shares. The growth in smart beta funds is also changing the equation a bit as they are active funds.
“They bet against market cap and if they continue to grow that should limit the distortion of prices just like active managers, although it is short term…That is what fund managers do, finding these opportunities.”
But Architas investment director Adrian Lowcock says ETFs are not the only cause of valuation distortions.
He says distortions haven’t reached alarming levels yet, citing the example of the FAANG stocks in the US technology sector, which despite being highly valued, are not at the levels seen during the tech bubble 20 years ago.
He says: “We have already seen valuations change [recently] but it could also be a momentum thing.”
Bioy says ETFs will continue to succeed for their flexibility to trade on the stock exchange as well as for their provision of liquidity when the market is volatile. She argues if some open-ended funds could trade on the stock exchange this could give them a further competitive advantage.
Since May, following initiatives of the Euronext Fund Service in Amsterdam, the Paris stock exchange has allowed open-ended funds (Ucits1 and Aif2) registered or passported in France to trade through their brokers.
There are currently 87 funds listed with the new Euronext Fund Service through providers such as Axa Investment Management and Natixis Asset Management.
The London Stock Exchange offers trading of some active ETFs from Pimco. The Italian Stock Exchange Borsa Italiana, which is part of the LSE Group, has been offering 100 open-ended funds globally since late 2014 as they are in high demand.