“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.”