The move towards fee-based advice that we currently have since the onset of RDR in the UK, occurred organically around a decade ago across the pond, which is one of the key differences between the two markets. But an increasing appreciation of the futility of following an active strategy is also changing attitudes here.
Despite a level of confidence in the fund managers who charge a premium for their services, a recent study by the Pensions Institute at Cass Business School found that just one in 100 active fund managers actually managed to beat the index returns between 1998 and 2008 after fees.
Professor David Blake who wrote the report, stated: “Taken together, the results prove that the vast majority of fund managers in our dataset were not simply unlucky, they were genuinely unskilled.
“However, a small group of ‘star’ fund managers are genuinely skilled and hence able to generate superior performance, in excess of operating and trading costs, but they extract the whole of this superior performance for themselves through their fees, leaving nothing for investors. While ‘star’ fund managers do exist, all the empirical evidence indicates that they are incredibly hard to identify.
“For most investors, our results show that it is simply not worth paying the vast majority of fund managers to actively manage their assets.”
When presented with evidence like this, it is no wonder the passive investment market in the UK is starting to grow, and it is being driven by the younger generation. More than one in six people aged 30 has a passive fund in their portfolio according to research from Bristol-based Hargreaves Lansdown, compared to the national average of one in nine, with five times more of their portfolio in tracker funds than those in their 70s. It has seen its tracker fund holdings grow by 50 per cent in the last 12 months, according to Adam Laird, passive investment manager for Hargreaves Lansdown.
He added: “Tracker funds are low cost, straightforward investments. Their simplicity appeals to younger investors who may be starting to build an investment portfolio. Costs have been falling and investors can now access all major bond and equity sectors for under 0.25 per cent ongoing charge.”
Charges are not the only consideration when choosing a tracker fund, said Mr Laird, but the relatively low-cost of trackers has undoubtedly boosted their appeal in recent years even though the concept of index tracking has actually been around since the 1970s. But its growth has been more evident in the last decade, and the Investment Management Association data shows that around 14 per cent of all equity assets are now in index funds, according to Ayesha Akbar, portfolio manager at Fidelity Solutions.
She added: “Increased choice is not the only factor behind the growing popularity of index funds. Management charges have been trending downwards and regulatory changes may be having an impact too - the move to fee-based charging and clean share classes has eliminated any issues relating to how advice is paid for. There may also be a growing acceptance that active and passive strategies both have their merits and can be combined together within client portfolios. All these factors could explain why, according to industry statistics, advisers are increasingly utilising index funds within model and bespoke portfolios.
“One of the benefits of index funds for an adviser is that they can reduce the amount of time required on fund selection and ongoing monitoring. However, while this is the case, it is important to recognise that index funds are not all the same. While passive solutions may appear to be very similar, they can actually be managed in very different ways. Therefore, as always, it is important to go through a due diligence process when choosing an index fund.”
US investors have been quicker to embrace the concept of passive investing than their UK counterparts, and there is an argument that this relates to the fee-based advice model being adopted for far longer in the US. The moves made through RDR are likely to help accelerate the adoption of index funds in the UK, along with the rising number of exchange traded funds which offer the cheapest access to a tracker available.
Vanguard is one of America’s biggest investment houses, and is a passive investment specialist that moved into the UK market back in 2008. It has already seen a significant change in UK investor behaviour since that time, and is expecting the fee-based advice model to fuel the demand for trackers even further.
Tim Huver, ETF product manager for Vanguard, said: “The markets in both the UK and US are very mature in the types and number of products offered, but where you have seen the difference is in the adoption of products.
“About a decade ago in the US there was this organic movement away from commission toward fee-based advice, and it moved the value towards financial planning. With that fee structure, the ETFs became a nice fit. In the UK with RDR, we are seeing what we feel is the start of a similar revolution of the market, where it is moving towards a value proposition for advisers moving from commission to fee-based. They are taking the whole of market approach, and we are seeing more interest from IFAs.”
When it first moved into the UK market, the fact that Vanguard does not operate on a commission basis meant that it took more time to increase its exposure to retail investors.
Mr Huver said: “In the UK for us, it has been a question of telling the Vanguard story. We are a mutually-owned company, so any money is put back into the funds to reduce the total expense ratios. We offer low-cost, properly diversified products that are not just a short-term strategy.
“When we entered the UK market, it was a payment for distribution infrastructure and we do not particularly fit in with that. But with RDR and not being a commission structure, it will give a bigger access for us.”
Tom Elliott, international investment strategist at de Vere Group, said: “The rapid growth of Vanguard in recent years, a US fund management company dedicated to passive investing, is testament to the enthusiasm with which US investors have greeted passive funds. Their Global fund is the world’s largest mutual fund. I believe that this is a foretaste of things to come in the UK, accelerated by RDR, as investors increasingly self-select their funds and will be attracted by the low fees.”
Vanguard has already seen a significant amount of interest in its ETF education data for advisers on its website, and given its average TER for an ETF is just 0.12 of a percentage point, it is hard to argue against the value.
Mr Huver said: “We know that advisers can add a lot of value in terms of their role in asset allocation, understanding the risk tolerance of investors, rebalancing portfolios, and talking to investors about behavioural finance.”
The move is not all adviser-led however, with the rising number of investment platforms in the UK that are either advice-led or DIY, which has also pushed the case for index trackers.
Yet despite the similarity of being low-cost, there are significant differences between each of the index funds, and this needs to be considered carefully when advising clients, said Ms Akbar.
She added: “As with reviewing any active fund, there are a number of considerations to be made when choosing an index fund. Different approaches can lead to different outcomes. For example, while one tracking method may be a particularly accurate way of following an index, the costs involved may actually make it less efficient in delivering the market’s return when compared to other methodologies. Some index managers also use practices which involve some risk and so it is important to know whether these can affect the fund and, ultimately, your clients.”
Of course, the downside of trackers is that they will follow the index down as well as up, with no room for manoeuvre on that point, and this can lead to underperformance that an adviser will be forced to explain.
Mr Elliott added: “Investors need to remember that a passive fund can never perform as well as its benchmark due to fees. This can surprise investors. Second, passive funds become forced buyers of stocks in the index they are tracking, irrespective of price. The larger passive funds become as a share of the total market, the more damaging this self-feeding loop becomes as funds try to catch up with the benchmark. Eventually this creates obvious overvaluation that only active funds are able to exploit.”
But as the Pensions Institute research clearly shows, active managers are consistently failing to do this.
Alison Steed is a freelance journalist
Key points
* About a decade ago the US moved away from commission towards fee-based advice
* US investors have been quicker to embrace the concept of passive investing than their UK counterparts
* The downside of trackers is that they will follow the index down as well as up, with no room for manoeuvre on that point
