Discretionary Management  

Due diligence should be done on passives

This article is part of
Guide to Discretionary Fund Management

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.”