It is a well-established fact that the passives industry has grown significantly in recent years in terms of both the proliferation of products available and the value of assets under management. According to the IMA, trackers now account for 10.1 per cent of total UK domiciled funds under management, up from 6.1 per cent a decade ago. Net retail sales of trackers have soared from £112m in 2004 to £3.2bn in 2013.
Of course growing use of passive open-ended investment companies (Oeics) and unit trusts in the UK funds industry only represents one part of the story around the march of passive investing. The really explosive growth has taken place in the world of exchange traded products (ETPs), which has been a global phenomenon. Figures from research and consultancy firm ETFGI have shown that the level of assets in these products has risen sharply in Europe. Indeed in 2005, ETF assets accounted for $57bn (£34bn). By June 2014, this figure had reached $445bn (£267bn).Globally this figure has rocketed from $450bn (£270bn) for ETFs in 2005 to a staggering $2,481bn (£1,492bn) in 2014.
While assets overall have been rising, recent years have also seen the launch of new ETP ranges which have started to explore parts of the market away from the mainstream equity indices. For example, we have seen a rise in alternative asset classes being covered, as well as ETPs that focus on particular parts of the equity and bond markets, such as European utility equities and short-duration sterling bonds. At the same time, there has been a rise in the popularity of ‘alternative beta’ indices which produce styles and characteristics that are different from the traditional market capitalisation-weighted indices such as the FTSE 100 and S&P 500. Popular examples of these are the equity income-style indices and the minimum volatility indices, but these really are just the tip of the iceberg.
This expanded toolkit is welcome news to both discretionary fund managers (DFMs) and institutional investors. It is little wonder then that DFMs in turn have become increasingly open to using passive funds within client portfolios alongside actively managed funds and, in response to client and intermediary demand, there has also been growth in passives-only solutions.
As well as greater product choice, there are other key drivers behind the increased use of passives by DFMs, such as a recognition that in some areas of the market the record of active management has been weak, as well as a greater focus on costs from intermediaries and their clients. This has been further fuelled – quite rightly – by greater clarity on charges since the onset of RDR.
The benefit of using low-cost investments in an environment of increased price sensitivity is self-evident. While passive funds offer a lower-cost means of accessing the markets than actives, the good news is that within the passives industry itself, a price war has helped to drive down the cost of these instruments even further. A recent example of this was seen in June when BlackRock cut the fees on six of its ETFs. Here, the provider reduced TERs by between 5 and 28 basis points. Fidelity has also made similar cost cuts on their range this year as competition has intensified.**
From a pure investment perspective however, the optimal approach is for a DFM to be neutral as to the use of passive and active funds. In isolation lower costs are always welcome, but clearly not if the outcome is lower returns net of fees. Active and passive investment strategies are too often falsely presented as polarised alternatives, but in reality each has its place within a well-managed portfolio, just as different investment styles do. There is no definitively correct way to manage a pooled investment: the success of a particular approach will vary depending on the prevailing market environment.
Just as it would be wrong to dogmatically only invest through actively managed funds, passive strategies should not be considered as a panacea to sweep away active management. Passive investing is a particularly effective way to access certain markets, particularly those which are highly liquid and where companies are heavily researched, such as US large caps. In these markets, information is abundant and flows around the globe in nanoseconds. Large companies in liquid developed markets are analysed by scores of banks, brokerages and fund managers, while corporates employ investor relations teams to help guide expectations. In such markets it is extremely difficult for active fund managers to add value by spotting attributes in a company that the wider market has missed. In these markets you need to be seriously good just to be average.
However, passive investing is less well suited to other areas, which are under-researched and less liquid. For example, active managers have a much greater record of success when investing in small or mid cap stocks. Indeed, over the last five years, more than 60 per cent of funds in the IMA UK smaller companies sector have outperformed their benchmarks.
Likewise, the market environment must also be considered when determining the right instrument to use in a portfolio. In a strongly rising market, in which a high tide raises all ships, a low-cost passive is an effective way of capturing market beta with minimal cash drag and frictional costs. However, in a falling or sideways market, stock selection becomes more critical, and an active fund may prove more appropriate, providing you pick the right manager.
Importantly, while the growth of the passives industry has seen a welcome proliferation of strategies available, there are still some asset classes that cannot be effectively replicated by a passives-only approach. These include physical property, operational infrastructure, private equity and venture capital, each of which might be best accessed through an actively managed closed end vehicle. An exclusively passive approach will inevitably have limitations for clients requiring a more customised and diversified solution.
In summary, passives look set to continue to be a growth area in the years to come, and are a welcome part of the overall armoury for DFMs. Exclusively passive solutions inevitably have limitations but some investors will be attracted by their lower costs. However, a sensible overall approach from an investment perspective should be neutral on selecting the right instrument for achieving an asset exposure at a given point in time to achieve the best outcome for the investor in terms of risk-adjusted returns after the impact of costs. Whatever approach is used – be it wholly active, wholly passive or hybrid – a robust approach to asset allocation is absolutely critical to achieving the right balance of risk and reward.
Miles Robinson is head of Tilney for Intermediaries
Key points
The passives industry has grown significantly in recent years both in terms of the proliferation of products available and assets under management
The benefit of using low-cost investments in an environment of increased price sensitivity is self-evident
While the growth of the passives industry has seen a welcome proliferation of available strategies, there are still some asset classes that cannot be effectively replicated by a passives-only approach
