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A Push into Passive Funds

Advisers may start pushing their clients away from actively managed funds and towards passive funds and ETFs

Fundscape 28 November, 2012 | 4:13PM

This article was written by Helen Pridham, the director of Fundscape. It was written specifically for Morningstar’s special series about the Retail Distribution Review (RDR) in the UK. It is part of Morningstar's "Perspectives" series, which is a series of articles written by third-party contributors. This articlewas updated January 2013, after originally being published November 2012.

The Financial Services Authority’s (FSA) new rules about how investment products are sold to individual investors were implemented at the start of 2013. The Retail Distribution Review (RDR), which outlines the new industry rules, was designed to ensure that individual investors get a more fair, transparent deal. But it looks like these new rules will have a variety of unintended consequences for both investors, advisers and investment providers. For example, the new rules could leave some investors without any advice if they cannot pay for the advice in a more upfront manner. The rules are also encouraging a move towards the increased use of passive investment funds by financial advisers, mainly for cost reasons. 

The Move Towards Passive Funds

Passive funds such as exchange-traded funds (ETFs) aim to track the performance of stock market indices, such as the FTSE All Share index.  To achieve this goal, they either buy all the shares in the index, invest in a representative sample or use other types of investment vehicles to track performance. The annual charges on these funds are low because they require very little active management and oversight; computers are generally programmed to track the relevant indices and this is relatively cheap.

Nearly 90% of the UK’s funds under management currently are actively managed

On the other hand, actively managed funds are more expensive to run.  Managers and analysts are employed to find, research and invest in companies whose shares are likely to outperform. Annual fees for actively managed funds are generally higher compared to passive funds, and this can put a drag on overall returns.

With a typical actively managed fund, the cost of investment management is generally 0.75% per annum (after commissions and other charges are stripped out of the overall annual charge of 1.5%). Meanwhile, for a passive fund the management charge may be 0.25% per annum or less.

Financial advisers have traditionally favoured actively managed funds. Nearly 90% of the UK’s funds under management currently are actively managed. But there is now a move towards greater use of passive funds. This comes as the new RDR rules move to eliminate adviser commissions.

In the pre-RDR world, advisers made the bulk of their money by recommending and selling actively managed funds and products that required investor to pay annual management fees each year, and then the adviser would get a sizeable cut of that fee. For an active fund that charged 1.5% per annum, it was typical for an adviser to receive 0.5% per annum in commissions. But as of 2013, these commissions are being abolished when advisers sell new funds to clients. Instead, advisers will have to ask clients for more upfront, transparent fees. Once commissions are taken out of the equation, advisers may not be so keen to recommend active funds to clients.

Furthermore, it appears that cost, instead of performance, is increasingly becoming important to advisers.  Lower charges on passive funds provide a way for advisers to bring down their clients overall costs without their own remuneration being affected. 

This shift in the financial advice industry will mean that advisers will have to make more investment decisions. They will have to choose which passive funds clients should buy and in what combinations. It could eventually have a knock-on affect within investors' portfolios, alter overall investment performance within these portfolios and create broad shifts in the overall investment industry.

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About Author Fundscape

Fundscape  is a research consultancy specialising in all aspects of the UK fund industry.