PassiveFeb 28 2017

Passives becoming a priority

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Passives becoming a priority

It is widely acknowledged that UK investors have been slower than the US to become interested in index-based products. Such has been the growth across the water that ratings agency Moody’s predicted in February that passives would account for more than half of US investment industry assets within the next seven years.

However, with growth starting to surge on this side of the Atlantic, too, the company believes that Europe will follow the same pattern.

Most notably of all, the ratings agency said it expected the shift to passive to continue irrespective of market conditions. The argument that trickier markets would mean a shift back to more flexible active managers, or that increased performance difference between shares would lead to the return of a stock-picker’s market, has been given short shrift in the face of the wave of money heading towards indexation.

The shift gets underway

In the UK, the transition has only just started to become apparent. Figures from the Investment Association (IA) show that tracker funds alone made up 13.5 per cent of all retail assets as of the end of 2016 – up from 11.3 per cent a year before. The proportion has almost doubled in the past five years, with the biggest leap coming in the past 12 months.

The reason for this most recent jump is that interest in passive funds displayed relative resilience at a difficult time for fund flows in general. Total retail sales for UK investors stood at £4.7bn last year, down 72 per cent from 2015 levels. In contrast, tracker funds saw net sales fall by 28 per cent to £4.9bn. 

This figure, which marks the first time sales of tracker funds have ever exceeded active fund retail sales in the UK, is more impressive still when taking a closer look at the data. Most trackers focus on equities – the asset class in which active funds suffered £8.2bn of outflows last year. 

Costs in focus

The shift is not necessarily driven by fund buyers and retail clients abandoning all faith in the merits of active management. But what they do seem concerned by is the high costs associated with active investing.

At a time when investment returns are widely expected to be lower in future than those to which investors have become accustomed in recent years, the cost differential between active and passive seems stark. If double-digit returns do prove much harder to come by, it makes it much more difficult to justify fund charges in excess of 1 per cent. 

The difference between active and passive charges has widened because of the price war playing out among providers of the latter products, according to the FCA. The regulator noted in the interim findings of its asset management market study last November that “charges for active funds have remained stable over time. By contrast, charges for passive funds have been falling in recent years”.

Active managers dispute this, saying the price of their products has begun to fall. Regardless, it seems incontestable that these drops have been prompted by the lower fees being charged by passives.

A retail or advised investor can now purchase certain tracker funds for an annual charge of 0.06 per cent (plus platform fee); the average cost of a passively managed UK large-cap fund is now 0.15 per cent, according to the regulator, compared with 0.9 per cent for an active equivalent.

The impact of the value chain

In public, the active versus passive debate has long tended towards the ideological. Advocates on either side have shown little sign of being willing to find a middle ground. Yet this is precisely what many advisers and other fund buyers are now doing. 

The growing scrutiny of intermediaries’ own costs has led them to seek a way to cap these charges. The best way of doing this, they appear to have concluded, is to seek more passive exposure in markets where this makes sense. 

The end of fund rebates may be have laid some of the groundwork for this shift. But it could also be argued that the Retail Distribution Review (RDR) has helped to support active managers. 

Discretionary fund managers (DFMs) are similarly shifting to a mix of active and passive products, but their rise to prominence could provide a bulwark of support for active funds, slowing the shift to passive if nothing else. 

DFMs under pressure to justify their cost to advisers will feel their strengths lie in fund selection as well as asset allocation. A shift to a wholly passive selection will give less credence to their argument.

In practice it has not proved so simple. The proliferation of products means fund selection can be a full-time task when it comes to passives alone, and discretionaries have begun launching passive-only model portfolio services in a bid to reduce costs to advisers. The question of whether this trend continues, though, is an open one.

“If you are a DFM talking about your asset allocation skill, and there are snouts in the trough, one way to alleviate that is to lose 60 basis points by going the passive route rather than going to active,” says Graham Bentley, managing director of gbi2, the consultancy.

“There will be more, I am sure… [But] it’s a question of what makes them more distinctive. If you will have similar asset allocations and they have passive, what makes them different from anyone else?” 

The rise of ETFs

Regardless, when it comes to fund selection, it is no longer just a case of buying an index fund for US equity exposure and going active elsewhere. Equity exposures of all kinds are up for grabs, as are other asset classes. And analysts say it is exchange-traded funds (ETFs) that will drive much of this growth in future. 

Among other factors, they suggest that the rise of robo-advisers, which typically invest in a basket of ETFs, will be important in this regard. But the current size of the market in the UK is difficult to gauge.

The IA says passives as a whole accounted for 26 per cent of the domestic investment market as of 2015, as Chart 1 shows. This measure captures some ETFs as well as trackers, making it a more complete measure than the 13.5 per cent figure mentioned above, but is still far from comprehensive. The trade body acknowledges that “much of the ETF market” remains excluded from its calculations.

What is for certain is that take-up of the products is less notable in the adviser community, in part because of distribution issues.

Nizam Hamid, head of ETF strategy for Europe at provider WisdomTree, says: “Increasingly, as you look at more diverse opportunities it’s also going to be done via ETFs. Trackers are relatively limited [in their exposures]. But the vast majority of interest in passives from the UK IFA market is in trackers because that’s what they can access most easily on platforms”.

Two of the big three adviser platforms: Cofunds and Old Mutual Wealth (OMW), are still yet to offer ETFs to their customers.

Progress on this front has been slow since Fidelity added external ETFs to its FundsNetwork platform in late 2015. Cofunds and OMW users will have to wait several months until their platforms’ respective technology upgrades are complete before the products appear.

Inevitably, all adviser platforms will have holes in their ETF coverage, given that there are thousands of such funds available to UK investors.

“Platforms will only put ETFs on there once an adviser says ‘I want to access that product’. Then we find they’re actually quite [efficient]. We always advise people to speak to the platform and they typically will just add the product,” Mr Hamid explains.

Several providers, including WisdomTree, launched the ETF Forum in 2016 in a bid to shed some light on this mass of products. But there remain few independent tools for assessing the merits of individual ETFs.

This appears a significant oversight, particularly when it comes to more complicated passive products. Two similarly named Value ETFs, for example, may track two entirely different value indices, meaning performance is unlikely to be identical for either. 

Advisers using the products should be conscious of these issues when performing their due diligence. As the FCA’s market study noted, “passive funds are likely to be assigned an average rating by some third party ratings systems”. 

Smart beta

The launch of products like this are indicative of how providers are looking to so-called ‘smart beta’ funds to usher in the next phase of growth. These are ETFs that follow an index based on a certain investment style – value stocks, for example – rather than a traditional benchmark based on companies’ market capitalisation. 

Smart beta has also allowed passive providers to make their case to fixed income investors. No longer are they obliged to buy the most indebted companies that make up traditional bond indices. Tracking only certain types of debt also makes it slightly easier, in theory, for passive products to dodge the bond headwinds. For now, though, fixed income is one area in which advisers tend to prefer active exposure.

Growth prospects

Some active managers appear to have conceded the argument and are focusing on areas that are harder to replicate by indexers. Absolute return and alternative income strategies are two areas that spring to mind. By coincidence, these are two of the most in-demand strategies for investors who are simultaneously cautious and yield-hungry. 

Passives are starting to encroach in other areas of the market, too. Vanguard’s LifeStrategy funds have grown considerably in recent years, enabling the asset manager to cut fees further last month.

Getting in on the act

Faced with competitors such as these, active managers have sought their own piece of the passive pie. According to the IA, just 11 per cent of its members currently offer ETF strategies. But its 2016 survey acknowledged “this is clearly an area in which [firms] are suggesting their presence is likely to increase”.

However, the growing number of firms seeking to involve themselves in indexation presents challenges for advisers as well as providers themselves.

Two firms – Vanguard and iShares – are increasingly dominating the passive market, using economies of scale to cut fees to levels that would be unsustainable for other competitors. 

With so many products available, the risk is that many fail to ever reach critical mass. As Table 1 hints at, even those that are popular do not see the kind of inflows associated with the most popular active funds in their heyday. Advisers will know from their experience with the active world that this runs the risk of creating a new cohort of sub-scale funds destined to be closed, causing allocations to have to be redirected.

The regulator may be investigating a lack of competition among active managers, but it could end up being passives that eventually suffer more seriously from this defect. Striking a balance looks like a sensible strategy for intermediaries to pursue.

“Most [fund buyers] will still be using active and passive, each way of management will have its own believers and they will both have a place in most investors’ portfolios,” concludes Chris Chancellor, a partner at consultancy MackayWilliams. 

dan.jones@ft.com