In Focus: Passive Investing  

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

  • To be able to explain the spectrum of passive funds.
  • To know more about the development of exchange-traded funds.
  • To have a better knowledge of what is driving innovation.
CPD
Approx.30min

"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.

"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."

This means that, unlike a classic passive fund that is constrained by its index, investors can be more selective about how they invest and perhaps avoid some of the high sector weightings in areas that a client might not want to invest in, such as oil and gas, or mining. 

According to Bailey, early academic research was largely based on the CRSP database of US stocks – a database of US stock market historic prices and returns – founded in 1960. Such a comprehensive amount of data on US stock prices and returns had never been available before.