This article is part of the Morningstar's Guide to Active vs Passive Investing. Click here for our edit on how the experts use the tools at their fingertips, finding out whether you prefer one to the other and examining how to blend active and passive investing for profit.
Investors are being warned passive funds carry hidden risks, and should be treated with as much caution as active investing.
Choosing investments based solely on the annual fee means investors may end up with exposure to companies and assets they do not wish to have, and risk losing capital.
These warnings came from Iain Richard, head of governance and responsible investment for Threadneedle. While it is unsurprising that an active fund manager is championing their own business model, Richard’s comments do have a factual basis.
“We recognise that both sets of strategy have their place to play, we will not be biased,” he said. “But we will stress the danger that can be dome from switching from active to passive funds.”
His comments come in reaction to a Hymans Robertson report into the role passive funds can play in the pension schemes of local government employees.
The report found that: “There are some funds which have performed consistently well relative to their peers. However, for the Local Government Pension Scheme taken in aggregate, equity performance before fees for most geographical regions has been no better than the index.
“This outcome is consistent with wider international evidence which suggests that any additional performance generated by active investment managers relative to passively invested benchmark indices, is, on average, insufficient to overcome the additional costs of active management.”
This trend towards favouring passive funds within pension schemes is not a new one, but has been accelerated by the pension charge cap due to be introduced in April. This means that for auto-enrolled default pension schemes, which 95% of workers are in, total annual charges must be 0.75% or less.
Even with the discounts offered by active managers to institutional clients on their funds, this figure squeezes out the ability for pension trustees to access many high performing fund managers and less liquid asset classes such as commercial property which come with higher fees. This means that diversification within pension schemes may be reduced, impacting final outcomes.
Modern portfolio theory dictates that diversification of assets within a portfolio reduces volatility and protects against losses – which is considerably harder to achieve with a reduced number of viable assets.
“The Hymans report calculates that moving their pension pots to passive funds would save Local Authorities £230 million a year, but carefully selected outperforming active fund managers could do more,” said Richard.
Value Creation with Active Funds
By switching all of your portfolio into passive funds, Richard says you lose certain levers for value creation. One of these is stewardship.
“Stewardship is an important part of active management, being able to choose not to invest in certain companies can be almost as important as who you choose to include in a portfolio,” he said.
Richard cited troubled service company G4S who had a number of public failures – the Olympics, overcharging the Defence Department, and a number of employee fatalities, after which Threadneedle chose to sell the company. Similarly, calculations proved the merger between Xstrata and Glencore would not be profitable in the long term for Xstrata shareholders and so that stock was sold.
“Passive funds cannot exclude certain stocks in this way,” said Richard.
Exercise Care when Choosing Passive Funds
Investors need to do their homework when buying passive funds in the same way they would when choosing an active fund. Investors may think they are getting exposure to small and medium sized companies when buying a FTSE All Share tracker – but as this index is cap weighted the largest proportion of the fund will be made up of large companies. Similarly the Goldmans commodities index did not include brent crude oil until 2012 – the one asset, alongside gold, you would expect to gain through a commodities index.
Morningstar analyst Hortense Bioy has highlighted the importance of understanding what you are buying when choosing an ETF to readers in the past, using the example of the FTSE 250 index.
“The FTSE 250 is a well-known and widely-followed index made up of the 250 UK stocks ranked below the FTSE 100 Index measured by full market capitalisation. However, investors should be mindful of the real composition of the FTSE 250. It is not a pure mid-and small-cap play,” she said.
“Almost 15% of its holdings consist of UK investment trusts – a mixed bag of assets, strategies and geographic exposures that have little or no connection to the UK mid-and small-cap market. In fact, the majority of the 43 investment trusts included in the FTSE 250 index invest in global equities and sectors.”
Strategic beta funds, also known as smart beta funds, can help with this problem.
Smart beta ETFs seek to enhance returns or minimise investment risks relative to a traditional market capitalisation-weighted benchmark. These ETFs, also known as strategic beta ETFs, are weighted by alternative variables such as dividend payments, volatility and earnings and exploit the same sources of return as active managers.
