PassiveJan 24 2017

Henderson flags suitability issues with passive funds

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Henderson flags suitability issues with passive funds

The fund house pointed to the mounting pressure to cut fund charges, meaning providers increasingly need to sell lots of their products to make their business models viable.

This, Henderson warned, could put an increased focus on quantity instead of quality.

Julien Cuisinier, head of investment analytics at Henderson Global Investors, raised potential suitability issues when it comes to the promotion of passive products, which are cheaper than active funds  - for example, that a growing focus on price could ignore portfolio construction and stock selection.

Mr Cuisinier said passive products which track an index need a minimum price to optimise the tracking, but warned some exchange-traded funds are finding it hard to compete because fees are being pushed so low.

“Those cheap ETFs don’t have the resources to add complexity to the way they screen stocks and create the portfolio," he said.

“If an adviser wants to add some more exotic kind of product to a client’s portfolio then it can become very hard to know what they are investing in.”

The analytics boss also pointed out that because passive funds simply track the market, decisions around diversification are pushed onto the adviser or end investor, meaning the provider can then “hide behind the market”.

We are concerned about the scale and pace of product proliferation in the industry.Nick Blake

Nick Blake, the European head of product and marketing at Vanguard, one of the largest passive players in the UK, said his firm is not under pressure to chase cyclical trends or ‘hot’ products when it comes to Vanguard’s own product line. 

He also pointed out economies of scale in the passive sector can benefit investors because this allows providers to return profits to investors in the form of lower expenses. 

“That said, we are concerned about the scale and pace of product proliferation in the industry, particularly in the more esoteric areas of the market.” 

He argued there was also a race by providers to differentiate product offerings, as they look to get more market share by widening their product lines.

When it comes to ensuring products are suitable for clients, Mr Blake said advisers are an “important safeguard” for investors.

“In our experience, many advisers have realised that low cost index funds are a great place to start, as they can fulfil the asset needs of many investors.

“For those with greater appetite for risk, active management offers potentially enhanced returns, typically at a higher cost.”

Dan Attwood, retail proposition manager at Legal & General Investment Management, which runs both active and passive funds, said scale is important in the management of index funds because it has an impact on costs and efficiency.

In this regard, he argued quantity actually improves the quality of an index fund.

Yet Mr Attwood also said investors should not just focus on fees when selecting an index fund, adding investors need to understand the exposure to the underlying index and have confidence the index will be tracked tightly. 

LGIM has amassed scale through managing assets for some of the UK's largest company pension schemes.

The company has £334bn in passively managed assets and £264bn in actively managed assets.

But Mr Attwood said individual fund launches are only ever considered "where there is tangible intermediary demand and where we believe we have the right skills to bring the fund to market at a great value price". 

“Although we are not responsible for individual client suitability where our funds are distributed via intermediaries, we are acutely aware of our responsibility to market funds sensibly and only to a defined and appropriate target market.”

Ben Seager-Scott, head of investment strategy at Tilney Bestinvest, said active management gives investors a second pair of eyes overseeing the portfolio.

Yet he pointed to Tilney research which indicated average active managers did no better than passives when avoiding the downturn during the global financial crisis.

“Of course, even with passives investors need to do their homework and not just look at the cost, but make sure the structure of the product is suitable, and the provider is not stressing the product to lower the fees through aggressive securities lending for example.”

Darius McDermott, managing director of Chelsea Financial Services, said care needs to be taken with all passive funds, adding the understanding of what is in a passive product is far more important than the cost when it comes to assessing suitability.

He used the passive fixed income market as an example, and said if investors buy a European fixed income passive product, then they are getting exposure to countries, such as Italy, which have the most debt.

katherine.denham@ft.com