Special Report: The rise of passive investing

This article is part of
Special Report: Hold your nerve and play the long game

Special Report: The rise of passive investing

When we decided 10 years ago to adopt the use of passive funds in our investment portfolios, our industry was very different to today.

In 2007, investment processes were less defined, Margot Robbie had yet to explain what a sub-prime mortgage was, and passive funds were only used by investors who were not capable of picking a talented fund manager.

It was against this backdrop that we started to adopt passives as the main building blocks for our range of risk graded model portfolios. Back then, the whole active versus passive debate produced views that were perhaps more polarised than they are today.

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Ask what is the biggest advantage of using passives and the most common answer is that of the cost savings. A typical equity tracking fund has a total expense ratio (TER) of around 15bps, with dealing costs contributing an additional 5bps. The average cost of an actively managed equity fund comes in somewhat higher with TERs at around 75bps, with dealing costs adding on average an additional 140bps.

Any IFA who sets out to pick active funds which consistently generate alpha will know that this is a difficult and therefore expensive task. That is not to say it is impossible, it is just that there are around 195 (bps) reasons why the passive route might give better returns.

Even for me – an advocate of passive investment vehicles such as ETFs and index tracking funds – it stands to reason that from time to time it should be entirely possible to actively allocate more funds to asset classes that stand to benefit from the prevailing economic conditions and less to those that may suffer. This being the case, then tactical management of asset classes should deliver better results than a purely passive strategy where assets are rebalanced back to long run strategic positions.

However, if the underlying funds are actively managed – by a “star” fund manager who has set out his stall as a stock-picker – then how can you be sure that your tactical asset allocation call is being implemented accurately?

What if your star manager decides he does not like the look of the market and stockpiles cash? All of a sudden your asset allocation has markedly changed. You may have backed the right horse, but you have got the wrong jockey in the saddle.

So, how have passive funds performed over the last 10 years? 

In the developed equity markets, we have witnessed significant underperformance of active funds versus passive.

Since May 2007, Legal and General’s UK Index Trust has grown 72 per cent, whereas the UT UK All Companies sector is up 66 per cent. Undoubtedly, a major driver of this underperformance is cost. The majority of these underperforming active funds are “closet trackers”, which are unwilling or unable to stray too far from their benchmark index. These funds offer none of the advantages of a skilled stock picking fund, nor any of the cost savings of a passive fund.