Due diligence should be done on passives

Supported by
Rathbones
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Supported by
Rathbones
Due diligence should be done on passives

The market and the regulatory conditions that have prevailed for much of the past decade have helped to boost the demand for passive investment products.

The policy of quantitative easing has boosted all equity markets, benefitting the passive investment funds that buy the whole market indiscriminately.

The lower fees levied by providers of passive products then further enhance the returns achievable from simply buying the market. 

The industry norm is to assume that the end client will not pay more than 2 per cent of their portfolio annually

Regulatory changes in the market over the past five years, including the retail distribution review (RDR) and the Markets in Financial Instruments Directive (MIFID) have served to place under the spotlight the fees paid by advised clients.

The fee is generally split between the investment manager, the adviser and the platform.

The industry norm is to assume that the end client will not pay more than 2 per cent of their portfolio annually for those three services combined. 

Minesh Patel, an adviser at EA Financial Solutions in London says regulation means more advisers are now outsourcing the investment management function to discretionary fund managers.

James Goward, head of sales support at wealth manager Rathbones says the changed regulatory world has also impacted the level of scrutiny on the fees charged by discretionary fund managers, as the end client becomes aware of what they are paying.

Mr Goward said this scrutiny has prompted a surge in the use of passive investment products by DFMs eager to keep costs down.

He says: “The requirement to present ex-ante and ex-post costs and charges information under MiFID II has put the spotlight on DFMs like never before. 

"This should be positive for advisers and their ability to make like-for-like comparisons between providers and making sure their clients are being appropriately serviced."

"However, it is important not to let the cost tail wag the dog. 

"Advisers will have often chosen to deploy the services of a DFM in order to access for their clients investment instruments and exposure to asset classes that are not broadly available. 

"However, it is important to remain cognisant of the portfolio construction and whether a low cost objective is simply being achieved by the use of passive investments."

Mr Patel says he has not noticed a particular decline in the fees charged by DFMs in recent times, despite the increased scrutiny.

He says the role of the adviser is to persistently challenge the DFM fee structure, as this helps the adviser to justify the fee they receive from the client. 

Charlie Parker is managing director at Abemarle Street Partners, an investment management and discretionary fund management firm that uses some passive investment products.

He said keeping fees low is part of the reason for this allocation, but said simply buying the index as cheaply as possible may not work as well in future as it has done in recent years, and if there is a steep and prolonged change in market sentiment, passive products may then underperform the market severely, rendering them poor value, despite the lower fees. 

By keeping interest rates low, the policy of quantitative easing has boosted the stocks that investors typically place within the “growth” category, including large US technology stocks and consumer staples companies such as Nestle and Unilever.

As those stocks are typically large parts of the global index, passive funds owned lots of stock in those companies, and so the end investor has profited. 

Jordan Sriharan, head of passives at Canaccord Genuity Wealth Management says: “Ultimately DFMs are judged on net-of-fees performance, how you arrive there is at your discretion (the clue is in the name). 

"What is of most importance is to understand that passive funds can generate a very different return profile than active.

"Through the course of a normal economic cycle, we are agnostic as to whether we invest in passive or active strategies.

"Principally that is because we recognise that different stages of the cycle will lend themselves to the style biases inherent in an active or passive strategy.  

"Equity styles change as the cycle changes but also as the global economy goes through its own changes. For example, the last few years have been a real technology story.”

A feature of the stock market in recent months  has been a shift away from some of those growth stocks and towards value stocks, that is, stocks which are more sensitive to the performance of the wider economy. 

James Klempster, investment director at MGIM, a discretionary fund house, said a major challenge for passive investors in the near future will be that if the present market volatility continues, and there is a mass sell-off, then liquidity could be an issue.

He said: “Performance of the passive vehicles that we use has been in line with expectations. 

"They have moved in lock step with the markets that they track.

"This is the benefit of doing detailed due diligence into what appear to be very vanilla vehicles such as trackers because the devil is in the detail and good due diligence ahead of an investment separates the wheat from the chaff; not all passives are created equal.

"If there is a period of profound volatility most well-structured vehicles will continue to perform in line with their target markets. 

"There might be issues experienced in less liquid markets especially if the passive vehicle suffers significant outflows.

"They may struggle to find sufficient liquidity to enable these outflows at a reasonable price if too much money ran for the exit. 

Deep and liquid markets such as large cap equity, investment grade and sovereign debt markets are the most liquid markets and that is where we tend to use passive vehicles.”

Mr Parker said:  “In our view, conventional indices will, over the next five years, significantly underperform value funds and indices built to capture the top quintile or value stocks globally.

"The danger of passive approaches is to focus too much on simple geographic asset allocation and miss these true drivers of outperformance.

"Over the past five years it was picking your equity style correctly - quality growth - that made the real difference. That may well continue to be the case.: