Surfing a passive wave

According to the Investment Association (IA), £1.7bn flowed into UK index-tracking funds and ETFs in March, almost half of all retail flows to IA funds. However, active funds still dwarf passives in total assets under management: active managers accounted for £4.39tn of total IA members’ managed assets at the start of 2016 (last measure), while passives were just £1.31tn.

Ironically, I think a good slug of the flows into passive investments over the past five years or more would have been from active managers. Passive investment vehicles are cheap, simple and usually liquid (although, not always and not all passives are created equal in that regard). Trackers and ETFs allow you to get short-term exposure to all sorts of assets very cheaply. It wasn’t so long ago that this was almost impossible to do, especially across varied assets, such as property, specific duration bonds, industries, foreign share markets and commodities. I use ETFs to get targeted exposure for short periods, whether that’s buying a Mexican equity ETF to hedge against rising oil prices or using FTSE 100 ETFs to add broad UK exposure when rebalancing portfolios.

This is really helpful! But, contrary to current popular opinion, I believe these index-trackers are only as useful as the person using them. Like a hammer, the best results are in the hands of a skilled tradesman. And you need more than just a hammer to build a house. Similarly, a lot more goes into the creation of a balanced portfolio than just one – or a collection of – indices. A good active manager is constantly monitoring correlations and performance of different assets within a fund, mandate or client account. They will also be taking into account when the client needs a withdrawal and thinking about which assets can be sold at a decent price to create the cash and which assets should be held for longer.

Many retail investors are buying and holding passives for many years or decades to get long-term exposure to markets. This is better than nothing – capital markets are the best way of making the returns most people need to fund their future, whether retirement, buying a house or putting their children through school. The danger is that passives may be riskier than many people realise. When markets are rising, passives give you strong returns for less cash in fees. But it is the same story when markets fall: passives will fall exactly in line with the market. You have zero ability to twist your investment into areas that will be less affected or avoid any bankruptcies that are within an index, even if they are glaringly obvious.

Many people may see the wave of passive investment and think they should join it. But I wonder how much of this cash flowing in is a wave of retail investors and how much is actually active managers surfing along the top.

If you’re riding the wave, you can adjust and better avoid the smashing foam when the wave breaks. You can’t do that if you are the wave.

David has written a report exploring how active managers can reclaim the high ground in asset management and why active investing may be better suited to the challenges of the years ahead. If you would like to know more, please call 020 7399 0399 or email us.