The introduction of exchange-traded funds that are cheap, transparent and easy to trade has heralded a recent explosion in the number of different types of strategies available to the investor.
Investing passively rather than opting for an actively managed fund has been possible for decades, ever since computers made it easy to calculate indices and generate up-to-date price movements.
Along with ETFs that simply track the FTSE 100 or the S&P 500, there are those that track different regions or sectors as well as different asset classes. There are also more complex strategies that will give the reverse of the performance or double the movement of the index.
UK versus US
The vast majority of these strategies, however, are currently only used in the UK by the institutional market.
Andrew Buckley, director at FTSE Group, says: “That is not the case in the US. Around 50% of the US market comes from the retail market. In the UK, it is only around 10%.”
While US retail investors will buy reverse and geared ETFs in the US, that is not the case in the UK. Reid Steadman, global head of ETF licensing, at S&P says: “Generally, these products are the preserve of professional investors who have the focus and the time to research these products.”
But Steadman thinks over time the UK retail market will become more like the US.
Educational efforts
Educational efforts will help to increase the use of more complex passive strategies but the biggest change will come from RDR.
Julian Hince, director at iShares, says: “RDR means IFAs will have to start considering ETFs as suitable products for their clients.”
Buckley concurs: “The vast majority of advisers are working on a commission basis and so they favour active funds as passive funds do not reward them to the same extent.”
More enlightened IFAs are already advising their clients to use passive strategies and ETFs in particular.
Promoters of passive investing point out the vast majority of active fund managers will underperform rather than beat the market and that past performance is often a bad indicator of future performance. Rather than wasting time and fees on an active management, a passive strategy will give the market performance at a much lower cost.
But most steer away from putting the whole of a portfolio into passive funds. Adrian Lowcock, senior investment adviser at Bestinvest, says: “It is not simply a case of always using a passive strategy because it is the cheapest option. You need to take different approaches in different markets.”
“For example, if you want to put some client’s money into large US companies, then it makes sense to use a passive strategy that tracks the S&P 500.
“The market is so efficient that it is difficult for an active manager to make a difference.
“But if you want to allocate assets to the Chinese market, then an active strategy makes better sense. You need a fund manager who is close to the market and who is meeting company management to be able to pick the good stocks and ignore the bad ones.”
Problems on the market
Lowcock says the sheer volume of passive products on the market can create problems.
“IFAs need to make sure they understand the mechanics of the products they choose to use. For example, some products do not invest in the underlying stocks but in derivatives instead which could introduce an unforeseen risk.”
Investing in passive strategies should not be a slap-dash affair. Tim Mitchell, head of listed fund sales at Invesco Perpetual, says: “When you are taking the passive route, you need to ensure you have a good top-down approach.
“If, for example, you are saving for your pension then you need to ensure you are designing your portfolio for growth so you need the right asset allocation to meet those objectives.”
Maximising
To get the most out of a passive portfolio, it is vital it is kept under the careful watch of an IFA, so investments can be sold at the right time to take profits and assets re-allocated to other classes.
Hince says this is already happening. “We have good evidence ETFs are being used to support a core investment strategy in this section of the market.
“For example, in the last quarter of last year, there was a 24% increase in funds invested in emerging market while assets under management in corporate bonds fell by 50%.
“A mixture of active and passive strategies is a way of blending the two approaches and giving clients a more diversified portfolio,” he adds.
Blurring the boundaries
The lines between active and passive strategies are blurring, with a growing number of strategies looking to improve the efficiency of passive strategies.
Mitchell says: “It’s been well-documented that funds that track market-cap weighted indices are inefficient. As the share price of a company increases, the index gains a larger proportion of that stock. That is the equivalent of buying when the price is high and selling when it is low.”
Rather than using market-cap weighting, the FTSE RAFI Index Series weights the stock according to sales, cash flow, dividends and book value.
Mitchell admits this type of strategy is conceptually quite a leap for many investors. “It can take time to educate investors about these types of products. This type of investment is often a contrarian investment. But then, the greatest investors have usually been contrarian investors.”
At this stage, it seems unlikely UK retail investors will be snapping up FTSE RAFI strategies in the near future but IFAs can not afford to ignore the challenges the maturing of the passive market poses.
Buckley says: “Advances in technology mean it will give retail investors access to a greater range of products they will be able to buy and sell with ease. IFAs will need to provide their clients with added value portfolio management services if they are to stay in business.”
