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Preparing for an all-passive world

Despite being around since the 1970s, index tracker funds did not have much love from investors until a decade ago, when Lehman Brothers crashed along with many people’s faith in financiers.

The popularity of passive funds grew steadily and they went from a negligible market share at the beginning of the millennium to making up almost half of all global equity assets under management last year, according to Investment Association data.

With active managers failing to significantly outperform passives at the time of the crash, investors’ fondness for passive funds continued to grow.

Royal London director of policy Steve Webb says: “Almost every day you would see stories that said ‘stick it in a bank, stick it in a tracker, no need for an active manager’.”

In a regulatory sense, while the FCA is clear it is neither pro-passive nor pro-active, it has put value for money under the microscope through its asset management market study, leading many to predict a movement towards lower-cost funds as financial planners try to make it easier to prove they are controlling fees.

Passives have also seen inflows as firms have set up risk target managed approaches to investing in a bid to reduce volatility in an uncertain economic and geopolitical climate, and discretionary managers and platforms have continued to launch their own passive ranges.

The growing popularity of passive investing has raised red flags at Royal London, Webb says. The firm has looked at what could happen if the steadily uphill trend of passive investing popularity continued to a point where most of the investing world – or all of it – would be passive.

In its latest paper titled “Could the Passive Investing Pendulum Swing Too Far?”, which spurred controversy earlier this month, Royal London envisions a world where most, or all, of the investing universe is passive.

It argues that the dominance of passive investing could hurt start-up funding and lower shareholders’ engagement in portfolio companies, which could lead to firms ending up with worse environmental, social and governance scores. But would innovation necessarily suffer in an all-passive world? Would the next Google or Facebook go unrecognised without active fund managers? Is too much passive investing really such a threat to the economy and society?

Passive “angels”

In the paper, Royal London states its concern with how new businesses, which are not already listed on the stock exchange, would raise investment funding in a world of an index tracker investing majority. The paper raises the question of who would fill the gap and allocate the capital in the absence of active management.

One fund investing in start-up companies believes the answer lies with private investors.

UK online equity investing platform Syndicate Room introduced its Twenty8 enterprise investment scheme two years ago and its portfolio consists of 28 unlisted companies. In this EIS, asset allocation is conducted by copying the investment decisions of private “angel” investors (who provide capital for a business start-up) and venture capitalists, making the role of active mutual fund managers in asset allocation obsolete.

Syndicate Room chief investment officer James Sore says: “Now we’re catering to the passive investors who prefer a portfolio approach to investing but don’t want to pay the hefty management fees that usually come with it. This new product offers a diversified portfolio for our investor community, while providing an even stronger route for companies to seek growth capital.”

Within the scheme, the traditional task of active fund managers is replaced by an algorithm that mimics the investment decisions of private investors. This automation makes it possible for the company to keep costs down.

Lower costs are without a doubt the passive fund’s main advantage over its active counterparts. However, strategies like Twenty8’s are slightly pricier than the average passive’s. The fund has a 1 per cent entry fee and 1 per cent management fee.

Solutions like this, which combine passive investing features with an element of active selection, could be the industry’s answer to the active-versus-passive dilemma.

Vanguard senior investment planner James Norton says: “Passive management doesn’t guarantee success, but it does drive costs down, meaning you keep more of the return to help you reach your goals sooner. That’s why we think passive investing is a great starting point for all investors.”

Adviser view

Alistair Cunningham, director, Wingate Financial Planning

Just deciding what sectors to invest into, and what proportions, is an active decision. If the whole market, minus one investor, was passive, the only active investor would have a huge advantage – they would be able to take account of the robotic nature of passive investors, for example by buying companies before they entered the FTSE or Russell indices.

The accountability problem

Apart from a less start-up-friendly environment, Royal London chief investment officer Piers Hillier finds “more worrying still” that in an all-passive or mainly passive world managers of British industry would go unchallenged without the active managers playing watchdog.

Royal London argues that the lack of active managers’ engagement could translate into poorer performance in the ESG arena. Active managers can punish companies’ wrongdoings by selling off their shares, the paper argues, while investors in passive funds are “stuck” in their holdings.

But proof of a link between passive ownership and poorer corporate governance is missing. This year, a University of Maine study on the impact of active and passive ownership on companies’ ESG scores found no relationship between the two.

According to Morningstar data, nearly 300 ESG index and exchange-traded funds had been set up globally by April this year. Combined, they have surpassed $100bn (£76bn) in assets under management.

However, research and rating agency FundCalibre’s managing director Darius McDermott fears that passive ownership of companies does weaken firms’ sense of accountability.

McDermott says: “I think the danger of having too many passive vehicles is that companies no longer have anyone to answer to.

“One of the big criticisms of fund managers is that they don’t challenge company management enough. But actually, a lot of challenge goes on behind closed doors, rather than in public. If it is just passive shareholders, there will be no challenge at all. When it comes to ESG issues, active management is key.”

Others suggest that while passive investing performs stronger in larger, more efficient markets like the S&P 500, active management is most likely to work where markets are less efficient and information flow is weaker, like for small-cap companies.

Adviser view Ben Yearsley Oversized 2012

Ben Yearsley, director, Shore Financial Planning

If you assume there are three different fees that a client pays – platform, fund charges, adviser fees – only one of those is affected by a wholly passive world. That’s the fund charges element, which could fall by about 0.5 per cent each year compared to what most clients probably pay. However, if there is no competition from active investment, where is the incentive for passive funds to lower fees? There is no reason for the other two elements to fall in price. An adviser would have the same level of work, as would the platform. If everything was passive, there would be no market anomalies and they would largely move up and down together as there would be nothing to drive individual share prices. It all sounds very dull.

Looking for balance

With regards to the question of whether a passive dominance could have any positive effect, Webb says: “I can’t think of any, to be honest. Everybody slavishly following [the trend] distorts the economy.”

However, while he cannot find any positive impact that all-passive investing would have on the economy, Webb acknowledges the advantages passive funds can have in individual portfolios. “It’s certainly a cheap way [to invest]. You could argue it allows people to invest money who could not otherwise afford it. At the very least, have several indices, so there’s some diversification,” he adds.

Despite the scenarios suggested in the paper, Royal London researchers do not argue against all passive investing and conclude the economy is better off with a combination of active and passive solutions: “There is no right or wrong answer to the active/passive debate and it is likely that a mix of both is required and that this mix will vary from client to client.”

Cazenove Capital Management portfolio manager Alex Baily argues for a combined active and passive solution.

Last year, Baily started an experiment in which he created a passive-only portfolio in line with Cazenove’s allocation view and tracked its performance.

Baily says that while the experiment is ongoing, the team already has some observations.

“It is difficult to replicate commercial property indices as you cannot buy a bit of every building in the benchmark, just as it is very difficult to buy a small share of a series of infrastructure projects,” he says.

Baily concludes that active and passive investment tools together complement each other.

Although Royal London’s paper warns the booming popularity of passives could go too far, Webb foresees a period where they fall out
of favour.

He says the acid test for passives will be the moment when stock markets turn downwards: “Passive funds might get a lot less fashionable when the market goes down.”

Shore Financial Planning director Ben Yearsley says that investment decisions would not necessarily get easier for advisers, as they would still have to decide from a range of passive options.

He says: “Just focusing on the investment side, if everything went passive advisers would still have to make similar decisions for their clients’ portfolios as they do today.

“The choices would be more limited but still wide. For example, do you track the FTSE All-Share or the FTSE 250? What about the S&P 500, or might you choose the Russell 2000 index?

“In the bond world, do you track sovereign, corporate or maybe emerging market bonds? Also, what about tracker funds versus exchange-traded funds?
“Going passive doesn’t really simplify much in investment and still leaves an adviser with many decisions to make.”

Expert view darius mcdermott

Passives will always lump the bad in with the good

I’m not negative on passive funds per se; I just think that if you can find a good active manager, the results can be so much better. Who wants to track an index if you could actually do better?

To me, passive funds are yesterday’s story. By their very nature, passives invest more in companies that have just done well or are popular – there is no thought involved as to whether the good fortune can continue or how much risk is being taken.

I prefer an active manager to consider the company fundamentals, the price being paid and how much of a weighting a company has in my portfolio. If they don’t like a company, I’m happy for them not to invest in it. A passive fund invests in a company whether it is good or bad. I’d argue that active investing is key when it comes to the health of the stock market and economies.

Passive funds should be as cheap as possible – less than 0.1 to 0.3 per cent.
If you are paying more than this I’d strongly suggest looking for an alternative.

Actively managed funds will be more expensive, but costs have come down in recent years and, at the end of the day, it is performance after fees that is the most important figure.

Darius McDermott is managing director at Chelsea Financial Services

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Comments

There are 16 comments at the moment, we would love to hear your opinion too.

  1. Passive funds ride on the back of actives and, by definition, can only ever achieve performance in line with the average of all actives ~ no better, no worse. The job of an active fund picker is to identify and then, on a regular basis, review funds which have and which are likely to continue to outperform the average. In an all-passive world, the ebb and flow of investment markets would be akin to that of the Norfolk Broads.

    • My feelings exactly Julian. They have their place but advisers need to find good active funds for their clients, to make a competitive difference.

      • If that is the only way they can make a competitive difference then they are in the wrong industry. There is no evidence that any adviser can predict which fund managers will outperform the index (in exactly the same way as no fund manager can predict which shares will) and their business model is therefore doomed.

        • So, in your opinion, the entire (active) fund management industry is based on nothing more than hype, hunches and guesswork and that all the processes on which stock selections are based, such as market analysis, research, meetings with companies to find out how they operate and critical analyses of their accounts and balance sheets are just a waste of time and money? And that third party assessments of funds by the likes of deFaqto and Rayner Spencer Mills are the same? And that a carefully considered, diversified and regularly reviewed portfolio of active funds will never outperform one based on a basket of index-trackers? Yeah, right.

  2. In a 90%+ passive world, what happens to the dividends?

  3. I think the reality is a lot different to this nonsense. Passive (market cap) will make up the majority of the market but the rest will be made up of active ETF’s and a consolidated active market with lower costs, it has to. Even if the market is 70%/80%/90% passive (market cap) then still the majority of trading will be done by the rest keeping markets efficient. Possibly easier to beat, but still winners and losers. Still extremely difficult to spot winners in advance.

    It is pointless talking about a passive (market cap) utopia because basic human nature will dictate that it will never happen. It’s like saying that all goalkeepers will stand still on penalties in the future.

    At the end of the day, the actively managed market has to consolidate, become more efficient and cost less for the end investor. It’s quite simple really. The majority won’t be around in 10 years, and that is why we see these scare stories. It’s just PR.

    • I would LIKE our goalkeeper (Petr Cech) to stand still on penalties. All he does is collapse, like a bag of cement, the wrong way. If he stood there he could just catch the odd one or two.

      Or maybe not.

  4. Passives have a use for active fund selection. In each sector a small (say 5%) allocation to passives will act as a benchmark to the 95% active portfolio. If you can’t do better than the passives then you are not doing your job. (That may mean using investment trusts in addition to OEICS)

  5. I might be missing the point here but if I’m reading it correctly, the EIS firm is plagiarising other’s ideas (and not rewarding them for their work).

    Imagine the uproar if it was found a fund manger was copying the ideas of other fund managers were doing rather than conducting their own research/due diligence.

    The argument for passives if often (vehemently) put and like many above, my starting view is neutral however, many arguments (on both sides) can be disingenuous. The bottom line is, what is the total cost to invest – are the ‘savings’ on passives passed to the investor or absorbed elsewhere?

    • Consider the performance of the INVESCO funds that Mark Barnett took over in the wake of Neil Woodford’s departure.

      As for charges, the prime argument in favour of a good active is that its outperformance should eclipse its extra cost over an ultra-inexpensive passive.

      The AMC of Virgin’s FTSE 100 tracker fund is 1% p.a. ~ yet investors in it seem to invest in it on the strength of the Virgin name, oblivious to the fact that some FTSE 100 trackers charge as little as 0.2% p.a.

      • Ah Julian. Why take the poor examples. Why not take a look at some Investment Trusts. Some of these make trackers look very sick indeed. Also look, for example, at Nick Train and Terry Smith.

        • Haha! I think debating whether goalkeepers should dive on penalties has more relevance that debating a passive utopia!!

        • As are most of my clients (on my advice), I’m invested in both Terry Smith’s and Nick Train’s Global Equity funds. In fact, I’m leaning more and more towards (active) global funds than anything else.

          Investment Trusts CAN do even better than a good Unit Trust, but they’re riskier territory and more difficult to explain to clients. And when they tumble…..

    • “Imagine the uproar if it was found a fund manger was copying the ideas of other fund managers were doing rather than conducting their own research/due diligence.”

      Isn’t that just a multi-manager fund?

      The reason fund managers don’t copy each others ideas is that no-one’s guesses are any better than another, so you may as well make your own. You have the exact same chance of success and you don’t risk the embarrassment of being rumbled.

      Trying to copy Woodford or another single manager wouldn’t work, because by the time you learned of their investments or divestments from the quarterly Morningstar update and copied them, the price would have completely changed, so your performance would be completely different. And probably worse because if a fund manager has a great idea, by the time you’ve copied it and successfully placed the deal, the price has already gone up (for buys) or down (for sells). So nobody is going to invest in a fund whose objective is “We’re going to copy Fund X but charge 0.05% less per annum”.

  6. There is a systemic/structural issue building which the regulators need to sit up and take notice about because it could trigger the next financial crisis.

    The point about corporate responsibility and being held to account has merit but aren’t there bigger issues here?

    At what point does the blind buying and selling of financial instruments, driven by the need to track an index, itself become the driver? If it does then you will get a cascade effect.

    Without someone to assess the value of a share and make a judgement there is no market and the trackers will have nothing to track.

    Index tracking is essentially a free ride. But as we know, there’s no such thing as a free lunch and someone, somewhere, is paying for it.

    On the flip side, when the point is reached where the trackers start to have undue influence, the active managers should be in a position to shoot the high value fish in the barrel.

  7. The vast majority of retail investors who invest in active or passive funds are not investing in innovative startup companies. By the time they arrive on the active fund managers’ radar they are already listed on recognised exchanges and are therefore open to passive funds as well.

    EISs are a totally different market to the active/passive debate. Angel / VC funding will never be an arena for passive investment.

    Passive investment cannot work without the filter of a regulated exchange to get rid of the scams and the honestly crap. It doesn’t work on AIM (an AIM all-share tracker would have returned minus 1.6% per year over a 20 year period) and it certainly wouldn’t work in the unlisted arena, even if it was physically possible.

    The Twenty8 fund is in my view not a true passive. Who made the decision of which angels and which venture capitalists to copy?

    That leaves ESG, which is not a concern as there are plenty of passive ESG trackers. Besides, I thought that ethical investments were supposed to outperform unethical ones nowadays, and if we don’t invest in them we’re all dinosaurs and millennials will take away all our AUA. If ethical investments outperform then even non-ethical-screening passives will invest larger amounts in them than unethical ones. Has the cycle flipped already?

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