While many advisers nowadays buy a mix of passive and active funds, some take a hardline approach, sticking strictly to either of the two.
But is there an ideal approach and to what extent should the cost tail wag the investment dog?
Morningstar's associate director of passive strategies, Jose Garcia Zarate, speaks to FTAdviser In Focus about how fees are a predictor of future performance and why zero-fee funds are unlikely to catch on.
FTA: When it comes to active and passive investing many advisers are choosing to buy while some favour one over the other, is there an 'ideal' approach?
JGZ: I’d struggle to say that there is an ideal approach, as it would be tantamount to saying that all investors are equal.
We have to be mindful of investors’ personal preferences. However, there are some facts that cannot be ignored.
First and foremost, regardless of whether one favours active or passive, fees are a good predictor of future performance. The less one pays on management costs the higher the chances of returns – provided, that is, that we have chosen the right asset mix and the best funds to build such allocation.
Let's not be fooled by a zero-management fee. It’s a cliché, but there's no such thing as a free lunch.
Second, for certain market exposures the probability to find active managers who consistently outperform the market is very scant. I’m thinking for example about US equity, where going passive has become something of a no-brainer.
This is not just a question of fees, but of realising that some markets are so efficient that the value of information is marginal and this close to nullifies the chances of successful stock picking with long-lasting results.
FTA: More money is moving into passive funds, so much so that some are warning the passive space could become 'too big' in five to six years' time. What's your assessment of where this is going?
JGZ: The passive fund market is certainly growing very strongly, particularly in the US. But by definition, the passive fund market can only be as big as the available pool of assets for purchase, and these assets are hardly the full size of any given equity or bond market.
Passive funds – exchange traded funds in particular, which trade on real time like a common stock – are built with liquidity as a paramount factor, as otherwise they would not serve their purpose.
FTA: When it comes to impact investing, how do you make an impact as an investor without being actively involved in shaping the companies' policies. Is screening enough?
JGZ: Whether one invests actively or passively, screening is a good first step. Screening is an active decision to carve out the investable universe and exclude certain sectors or companies/countries, which is a strong statement of intent per se.
But on the question of how passive investors can influence companies if they cannot divest from them, as long as they are in the index, the answer is engagement.
Engagement is time and resources consuming, but as long-term holders, passive funds have a strong vested interest in making sure that companies are managed correctly. After all, a company that is well managed should see its valuation rise. This will benefit investors and passive fund providers alike.
I’d rather not be blindsided by a zero-fee headline only to be charged elsewhere in a way that is not readily identifiable. Given the low fees that passive funds charge, it’s clear that the higher the AUM in passive funds, the higher the total fee revenue stream. So even if one only does it for the sake of profits, passive fund sponsors have a very strong vested interest in ensuring that the companies they invest in are well managed.
FTA: More bespoke passive (ie ESG) funds tend to be pricier than standard passive funds. How do you see this change in future?
JGZ: It can be argued that there may be an incremental cost to building ESG benchmarks as you’d need extra research, for example in the shape of ESG ratings and data that needs to be paid for.
Meanwhile, as per the actual management of an ESG versus a mainstream passive, I don’t see that there are crucial differences that would justify a higher fee. So in the end, I guess that the main factor behind any fee premium between mainstream and ESG passive funds is likely to be index licensing costs.
I'd say, however, that when passive fund providers started launching ESG funds a few years back, the fee premium versus plain vanilla was more prominent than it is now.
The fee gap has been shrinking and it's not difficult to envisage an environment where both ESG and mainstream are priced equally. In fact, some of the ESG passive funds launched nowadays are cheaper than legacy mainstream peers.
FTA: Since about 2014 the price of passive investing has fallen steadily. Is there a limit as to how low prices can go?
JGZ: Well, in the US there are zero-fee ETFs. So, I guess that's the answer. But let's not be fooled by a zero-management fee.
Some of these zero-fee ETFs in the US were launched as marketing gimmicks and haven't really attracted much interest. It’s a cliché, but there's no such thing as a free lunch.
Asset allocation in relation to our risk profile is key, and once we get that right, then the lower the fees we pay the better.We always end up paying something somehow. And I'd say it's only fair that we do. I’d rather not be blindsided by a zero-fee headline only to be charged elsewhere in a way that is not readily identifiable.
There's work behind any investment fund and that needs to be properly accounted and paid for. The investment fund industry is not a charity and we investors need to pay for the service provided to us.
What we must demand is a fair and transparent fee structure.
FTA: Should charges dictate investment decisions?
JGZ: Tricky one. Low for the sake of low is not good enough unless it translates into a good outcome.
Asset allocation in relation to our risk profile is key, and once we get that right, then the lower the fees we pay the better.
carmen.reichman@ft.com
