Fund Selector: Pairing passive with active

The growth of the passive market is a much focused upon topic.

This debate is often framed in binary terms, which can lead to exaggerated statements regarding the potential threat of passive investing on the active management sector in general.

Ultimately, our view is that passive strategies are a healthy force within the market, which can provide much needed competition within the industry. Such techniques also give fund managers more tools in the box to use in conjunction with actively managed funds in accessing markets and managing risk.

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In the past decade the pace and magnitude of growth of the passive market has been material, with the sector experiencing a 10 per cent average annual growth rate, with passive funds now making up 22 per cent of UK assets under management.

This growth has been particularly marked for those vehicles offering intraday liquidity, such as exchange-traded funds.

There are a number of theories as to why this trend has evolved, but, as with most things, it relates not to one but a confluence of factors. Some of these include an increasingly cost-conscious market, a regulatory framework favouring simplicity and transparency, a heightened focus on performance certainty, together with the numerous studies that have challenged the success of actively managed strategies in certain sectors.

All of these factors have made investors less tolerant of actively managed strategies that charge premium pricing but rarely outperform the index.

We would argue the growth of passive strategies is part of a natural evolution of an industry structure within a competitive environment. Nonetheless, this restructuring of market share between passive and active approaches is ultimately being led by investor demand.

As requirements from the demand side evolve – whether that is driven by the sophistication of the investor base or more regulatory-led – this naturally generates an adjustment of the supply side requiring the product providers to further innovate and improve.

That is why, in the absence of insurmountable barriers to entry, the passive sector took the opportunity, and ultimately the customers will benefit. This does not mean the death of active management, but rather a welcome catalyst for progress.

Nevertheless, the debate surrounding using actively or passively managed vehicles often gets confused with whether you take an active or passive approach to portfolio management. This is mistaken, as it doesn’t take into account the multiple layers of active management that exist across a multi-asset portfolio.

These span decisions relating to asset allocation, style considerations, and the type of managers chosen, to the levels and different ways of measuring and managing the active risk taken.

Of course, ultimately many other variables need to be addressed, and this complexity demonstrates the importance of a robust decision-making framework that can deal with this challenge. The investment process is paramount. That is why we should see the evolution of the passive market as a new industry trend that provides us with an additional and valuable tool to use.