Cost and value were the central factors in the active or passive debate 15 years ago and it is much the same today, the major difference being that funds find themselves in competition with their own peers rather than each other
Passive funds are becoming more low cost while active funds with proven added alpha can command higher than typical fees, a process expected to accelerate. Products in the middle, the mediocre actively managed and high cost trackers, are likely to be the most affected in the fall out of this growing trend.
Changing regulations regarding distribution, added competition and a renewed focus on value-for-money post the credit crisis has reignited the decades-old debate of passive versus actively managed funds.
Cost and value has always been central to the debate of passive versus active. Today it is no different but instead of competing against each other pressure is being felt at both ends by their own peer groupings.
Andy Clark, managing director of wholesale for HSBC Investments, pointed out the debate concerning active and passive funds is the same today as it was 10-15 years ago, the arguments having come full circle. The lost decade of investment returns has heightened attention paid to funds which charge 1.5% but haven’t really delivered, Clark said, which puts pressure on the active side to justify their charges.
Simon Ellis, managing director unit trusts at L&G, noted net of fees, many actively managed funds do not deliver and act like closet index trackers, delivering little in the way of value. According to research from Thames River Capital’s multi-managers Gary Potter and Rob Burdett the number of funds performing consistently well is falling instead of improving.
In examining the last quarter of 2009, the number of funds achieving top quartile returns consistently is down to the lowest level the two have ever recorded at 0.9%, a drop from 2.2% in the third quarter. In the main 12 IMA sectors researched there are 1,065 funds with a three year track record ending 31 December. Of this 1,065 just 10 (0.9%) have been top quartile in each of the past three 12 month periods. Even if just above average performance is examined the results are not overwhelming with 119 of the 1,065 making the grade.
Burdett and Potter noted there is not a single fund in the IMA Global Bond, Global Emerging Markets, Global Equities or UK Smaller Company sectors that has been top quartile over the three years to the end of 2009.
Richard Romer-Lee, research director at Old Broad Street Research is an advocate of actively managed funds although he too admits there is a certain amount of dross out there.
“There are many active managers who are not that good at what they do and are therefore not worth the money people pay for them,” he noted. But, he said, if IFAs do their research they can find many portfolios that are worth their fees. Romer-Lee commented that there are several managers who can command higher fees because they have proven their ability over time.
The growing Absolute Return sector is evidence of this, many portfolios of which managed to keep from losing money even amid the dramatic downturn in the market during the credit crisis. Blackrock’s UK Absolute Alpha has returned more than 20% over the three years to 18 January while the average UK All Companies fund has fallen 7.7% and one of the best performing passive funds within the sector gained just 0.6%, according to Trustnet figures.
The price factor
The difference in the performance of funds which track the various indices often comes down to price.
The legacy of trackers is that many still feature quite high charges, left over from when they first launched when there was little pressure to lower prices beyond being cheaper than active funds. There remain a number of passive funds which charge 100bps a year for their management.
More recently though increased competition, both from new providers and the rise of ETFs, has added pressure to lower costs. The US giant Vanguard entered the UK market last year with a number of passive funds featuring total expense ratios of just 0.15%.
While they may be the cheapest, there are many other groups which have lowered their prices already. Companies such as M&G, Fidelity and L&G all feature TERs on their passive funds of less than 0.55%.
RDR
One aspect that is widening the gap between active and passive is the forthcoming Retail Distribution Review.
With the loss of commission, advisers will be looking for ways to keep costs low for their clients, creating greater demand for passive, Clark said. Post RDR it is expected retail use of passive funds will mirror that of the institutional market place where there is demand for these vehicles as core holdings, with active funds adding alpha in satellite positions. According to the IMA’s annual survey of the industry published last summer, 23% of UK institutional investor assets are passively managed.
At the moment retail investors put much less money into passive. In 1999 gross retail sales in tracker funds amounted to just under £2bn whereas in 2008 it was £1.8bn, IMA stats show.
Passive funds accounted for 4.9% of funds under management in 1999 and 5.5% almost a decade later. And although there are more than 2,100 funds in the UK onshore market to choose from, very few are passive vehicles. According to IMA statistics the number of tracker funds in the UK market has been steady for more than a decade with 70 tracker funds available in 1999 and 71 as of Q3 2009.
Clark doesn’t believe an increase in demand for passive alternatives will decrease the focus on active funds. It is not a case of one or the other but each facing pressures within their own camps. “Active won’t die but people will have to pay for the best and funds that don’t stack up will suffer.” Romer-Lee agrees: “An index reflects what has happened in the past, not the future – it provides correlation, not outperformance so unless the world loses its sense there will always be a place for active managers.”
With the widening gulf and pressures at either end, Ellis said education will be key. As passive funds compete more attention will need to be paid not just to price but to the methodology of the individual funds as well as to what goes into tracking errors. For instance, he noted, counter party risk is a component of some passive funds that is likely to come under greater scrutiny as they rise in popularity.
Although many talk of the low cost nature and transparency of ETFs within the passive world, there are more to these vehicles that needs to be understood as accessibility to these products improves, Ellis pointed out. One element is that they are not necessarily as cheap as many anticipate, carrying with them broker fees that can push their cost up. Looking at a small grouping of ETFs and their TERs they are comparable to passive funds rather than cheaper.
Lipper stats show the TER of a number of ETF products as ranging from 0.30% to 0.75%.
With education and accessibility investors could find that both types of passive vehicles have a place within their portfolios. Ellis said: “It could be that ETFs are better suited for access to specialist markets or asset classes or used for shorter term tactical sector or style bets but major asset classes and markets could be better served through a fund.”
