The perils of passive funds in an economic storm

7th August 2012

Sales of passive funds were higher than active funds over the past six months. The Investment Management Association said £1.01 billion was pulled out of active funds, while £272m was ploughed into tracker funds, reports the Sunday Times.

The total annual cost of an actively managed fund averages 1.5%, compared with 0.7% for a FTSE tracker fund.

Passive vs. active

Passive funds track the performance of a particular market or index, rather than aiming to beat it. They are marketed as a low-cost, transparent option for investors seeking equity exposure. Alternatively, active funds enable managers to pick and choose the stocks.

For example, exchange-traded funds, listed on the stock market, enable investors to track the performance of the price of, say, gold, while also offering a liquid market to buy and sell the value of the asset easily.

The increase in sales of ETFs, reports Bloomberg, shows investors are giving up on picking stocks and searching for value in favor of computer-driven strategies, and they're fed up with the fees managers charge without delivering adequate returns.

The number of exchange-traded funds has ballooned in recent years from funds simply enabling people to track the FTSE 100 or FTSE All Share.

As investors channel more and more money into these funds, the ETF industry continues to chop up the world of securities into pieces, allowing investors to put money into regions, asset classes, or investment themes; anything from gold to agricultural companies.

So what are the pitfalls?

Beware ‘synthetic' ETFs. If they are ‘physically backed', which experts usually recommend, they hold the actual assets that they seek to track, while there are also those that do so by means of complex instruments such as derivatives, which are called ‘synthetic'. Also ensure they are run by one of the big issuers such as iShares or Deutsche Bank.

Also, passive funds always underperform their index over time, as although charges are low there is still a cost that drags back performance.

Darius McDermott, from IFA Chelsea Financial Services says that investors shouldn't be scared into the passive route on his Mindful Money blog: "They (investors) shouldn't be frightened by the market falls we've seen over the last five years because there are companies out there that are doing well.

"But what they don't need in this environment, in my opinion, is a passive fund. Right now, you need a decent active manager who can find companies which will do OK, no matter what the outcome of all this government intervention is, no matter how flat the economy might be.

"And looking back over the last five years, the statistics are starting once again to favour those active managers. Over the last five discrete years to 26th June 2012, the average fund in the UK All Companies Sector has beaten the average index fund in every period. Cumulatively, the average active fund has achieved double the returns. And that's just the average. The really good active managers have more than proved their worth."

Andy Parsons, head of investment research at The Share Centre, takes a balanced approach on a Mindful Money blog: "We are often led to believe that stock markets are efficient, and if this holds true the argument for passive investing and an index fund would suffice.

"However, as we have seen over time, not all markets are efficient and valuation anomalies do occur; it is for these reasons that the argument for active management persists. Personally, I believe there is a place for both, depending on the investment objective of the investor."

Don't think passives are immune from financial scandal, either.  Popular, low-cost funds could become more expensive following the introduction of new European rules, warn reports.

The European Securities Markets Authority has proposed that all profits made by fund managers who lend out stocks should be returned to investors.

Stock lending is particularly prevalent in passive, exchange traded funds, where holdings are traded less frequently and can be "hired out" relatively easily, warns the Financial Times (paywall).

A recent survey by SCM Private showed that half of the largest UK fund managers lent out stock and on average pocketed a third of the income generated, says Citywire.

 

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