All you wanted to know about ETFs (but were afraid to ask)

Tim Morris, adviser at Russell & Co, often uses ETFs in client portfolios. He comments: "Increasing use of passives has massively helped drive down the costs of investing in recent years."

Kenneth Lamont, senior analyst of passive strategies, manager research at Morningstar, agrees cost plays a big part. 

He says: "Our own research has shown that fees are the most reliable predictor of future fund returns (lower fee predicts higher returns).

"There will usually be numerous active managers that outperform the market over short investment periods, but this number drops as the investment timeframe lengthens in almost all markets."

For example, latest Morningstar data show fewer than 5 per cent of European active managers investing in large-cap US equities survived and outperformed their passive equivalents over the trailing 10 years.

According to Lamont: "This illustrates how the odds are stacked against you when picking an active manager for long investment horizons. For this reason, the advice of Buffett still holds."

Need for development

However, this is not the be-all and end-all to passive investing, and active managers have been shown to be more successful in some markets than others, while others claim the higher potential alpha generated by active management outweighs the higher cost. 

Bailey comments: "Academic research showing a passive index-tracking portfolio is a better option for investors (the premise underpinning most index-based funds) than actively managed funds can be traced back to the 1950s.

"This eventually resulted in the launch of index funds in the 1970s."

But there is the question of correlation and diversification to consider when index-tracking; investors can end up with high weightings in certain sectors simply as a result of traditional market-cap weighting. 

Morris adds: "As with anything in life, there is never one winning formula. And even if there was, it wouldn’t come without its issues.

"For example, tactical asset allocation can only get you so far should bonds once again become correlated to equities.

"Those who invested in the 20 years prior to the last 20 (so pre-2000) would be familiar with positive correlation between bonds and equities.

As with anything in life, there is never one winning formula.Morris

"And ever since quantitative easing started in 2009, many investment bankers have been wary of overly inflated bond prices."

This perhaps explains the popularity of ETF investing: it can offer a low-cost, 'passive' style investment product to consumers, but with an overlay that allows for more flexible and tailored investments.

Morris explains: "The increasingly sophisticated nature and increased flexibility of ETFs explains their rise in popularity.

"Their ability to replicate direct holdings in an asset class and for leveraging means they have much broader appeal, especially when it comes to sustainable, or impact investing."