Your IndustryDec 4 2013

Pros and cons of a passive approach

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As the passive portfolio is ‘tracking’ the reference index, Robin Stoakley, managing director for UK intermediary at Schroders, says investors should be able to have a high degree of confidence that they will perform broadly ‘in-line’ with the reference index.

But Mr Stoakley adds while the passive portfolio will track the index, the degree of ‘closeness’ will depend on the quality of the program used to manage the portfolio and the efficiency of stock trading.

While passive portfolio management has become more efficient inherent variances from the chosen index can and do occur, especially where a sampling method is used depending on exceptional performance of individual stocks.

Secondly, he points out charges will be deducted from the portfolio thus guaranteeing that the passive fund will actually underperform its reference index.

Ben Yearsley, head of investment research at Charles Stanley Direct, agrees that the “main negative” of tracker funds is “guaranteed underperformance of the index”, in contrast to active funds which have at least the potential to overperform significantly.

However, he points out that despite the inevitable hit on performance one of the positives of passive funds is their lower price compared to active alternatives.

Charges vary depending on the scale of the fund and manager, and the index that is being tracked. Some trackers, such as the Halifax UK FTSE All-Share Index Tracker, have share classes charging as much as 1.5 per cent, while fees can be as low as 0.1 per cent. C-class fund

Mr Yearsley argues passive fund annual management charges should not be more than about 0.2 per cent, compared with about 0.75 per cent a year for actively managed funds.

Alan Miller, co-founder and chief investment officer of SCM Private, claims the difference between charges for passive and active funds understate the cost benefit of going passive. In fact, he claims after-cost returns are typically lower in active funds on average.

For example, he says a FTSE 100 tracker can be bought for an all-inclusive cost of 0.1 per cent a year compared against about 1.7 per cent a year for an equivalent active fund.

Mr Miller says: “The simple maths is this: most active fund managers make up most of the market so their return before all costs will always be on average close to the market return, but because their charges are much higher, their after cost returns will normally be lower than a passive fund.

“As compared to the market return, the differences between a good and bad passive fund are relatively small whereas the range of returns for an active fund will be colossal.”

He adds one of the great hidden costs of active funds is transaction costs.

He says: “Every time a manager buys or sells a share or a bond there may be substantial taxes, commissions and market maker spread related costs.

“Because the passive fund will normally deal much less, being ‘forced’ to deal only when a constituent enters or leaves the relevant index, this extra drag on performance will be much less.”

Mr Miller says the downside to passive funds can be getting the timing right, in terms of when to buy or sell the index.

He says: “Some indexes may be more concentrated than others and ultimately their attraction will depend on the attractiveness of the largest underlying constituents.

“It is unlikely that you will get rich quickly as this normally requires higher risks to be taken or to concentrate on a handful of ideas rather than a large basket of stocks.

“If the market goes down then almost certainly your passive fund will fall by the same amount plus costs.”

Andrew Wilson, head of investment at Towry, states there are many reasons advisers and investors should consider passive funds. He points out these vehicles are a relatively cheap and easy way to capture the broad return of a market or index.

However, he cautions that as there is no subjectivity involved in passive funds, this also means there is no assessment of security valuation or risk.

Mr Wilson says advisers due diligence questions on passives should include:

1) Does the fund own part or all of the underlying index constituents, or does it capture the index return synthetically (i.e. through derivatives)?

2) How well does it track the index, and what is the impact of fees, including dealing spreads?

3) Is the cheapest tracker the best at replicating its underlying benchmark, and is it the most appropriate for a client, and with less explicit and implicit risk?

Mr Wilson says: “Few active managers outperform, and even fewer with any degree of regularity.

“Additionally, there are extremely hard to spot in advance, and even after the event one needs to decide whether it was down to skill or luck. Active funds can also underperform quite materially, which is a significant risk.

“Indeed the money weighted return of funds is often considerably worse than their average return, and the same for a sector of funds.

“Money only flows into funds after they have already performed well, but then fully participates in any mean reversion of performance. No manager’s style works throughout the economic cycle.”