As ETFs become ever more popular, where is the active v passive debate now?

Elliott Haworth
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Choosing between active vs passive investing is no longer an easy decision (Source: Getty)

Investment in exchange-traded funds (ETF) has boomed in recent years, attracting particular interest among a younger investment audience. At the end of February, there were 882 ETFs listed on the London Stock Exchange alone.

One of the advantages is their simplicity and transparency: although there is a small number of actively-managed ETFs, the vast majority are passive, attempting to emulate the performance of a market, commodity or asset class, and enabling them to keep costs much lower than an actively managed fund.

They hold advantages over simple tracker funds too. Listed on an exchange, their price adjusts over the course of the day based on supply and demand, so they can be used to take advantage of short-term market moves as well as long-term trends.

There are countless ETFs available, from the broad-based, tracking major indexes such as the FTSE or Dow, to the more specialised, offering access to emerging markets, specific geographies and regions, or those tracking sectors – or even multiple sectors. The possibilities are near enough endless.

But as largely passive vehicles, are they right for your portfolio? And what use could they have in the current market environment?

Does what it says on the tin

The main difference between active and passive funds, unsurprisingly, is that the former is managed “actively” by a fund manager seeking to achieve outperformance. By applying human intelligence to asset selection and a whole variety of other factors, the manager will hope to provide higher returns than simply holding a smattering of all the stocks in an index or region. Passive funds, by contrast, offer investors similar levels of risk and return to the market proper, and will in fact underperform their benchmark over time because of fund costs.

However, active funds, due to the cost of human management and frequent trading, have much higher fees than their passive siblings. The annual average disclosed fee for actively managed funds available to UK investors is 0.9 per cent, compared to the far lower average passive fee of 0.15 per cent. This should, in theory, be worth it. After all, you are paying for a professional to manage your money. Unfortunately, it is not always the case.

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The Great Debate

In November last year, the FCA released the results of an excoriating inquiry into “a lack of competition and value for money” in the asset management industry, re-opening a rift between proponents of active and passive investment. The report concluded that the costs of active management frequently outweigh the benefits, and that while active fees have remained largely the same in the past decade, passive fees have been in steady decline. Passive funds now represent around 23 per cent of the assets under management in the United Kingdom.

According to the report, investors would have earned £9,455 more by investing £20,000 in low-cost passive funds tracking the FTSE All-Share over the past two decades than in the average active fund, rising to £14,439 if transaction costs are taken into account.

Complement or competition?

Ursula Marchioni, head of portfolio analysis and solutions at BlackRock, says that active funds have been somewhat tarnished by what she refers to blithely as “Bench Huggers” – those managers that have “posed solutions as active but have ultimately delivered something close to bench.” According to S&P analysis, 87 per cent of active UK equity funds underperformed the market in 2016.

Nevertheless, she says, “‘real’ active managers that deliver unconstrained strategies and deliver value to clients through their insight have a very bright future.” There are active managers out there that can add real value.

“A lot of people view active and passive investing purely in competition terms, one versus the other,” says Simon Klein, Deutsche Asset Management’s head of ETF sales for Europe and Asia. “But in reality both approaches can complement each other and are often used by investors together. So, for example, an investor might use low-cost passive investments for the core part of their portfolio but use carefully chosen active funds as satellites to try to target outperformance.”

But why has there been such a large increase in investment in passive funds like ETFs recently? “The uptake of passive funds by increasing numbers of investors is part of a broad, long-term trend,” says Klein. “In a low interest rate environment which has driven yields across asset classes to historically low levels, investors are very much focused on minimising fees to maximise long-term returns.”

Judging the fund

Maike Currie, director at Fidelity International, agrees that the answer to the active versus passive debate “often lies in a mixture of both approaches”. But, she says that in the current environment of rising inflation, low interest rates and jittery markets, “rather than focus purely on the headline costs, what investors should really look at is the total return after charges. By investing only in low cost, passive funds [simply because they are cheap] you could potentially miss out on the outperformance that a skilled active manager can deliver.

“When you factor in the mathematical marvel of compounding, even a relatively modest annual outperformance by a skilful manager can add up to a massive outperformance over the long run, which means the rewards of active investment can often justify the small additional cost.”

Buy and Hold

It’s a Tortoise and Hare scenario. Despite keeping initial and ongoing costs ultra-low, passive funds won’t beat the market. Nor will they fall far behind it, however, and in theory at least slow and steady investing will win the race.

But although the shift towards passive funds is part of a wider macro trend, says Marchioni, active strategies offer investors “the ability to adapt to an environment that is evolving and changing into something we’re not acquainted with – Black Swans or big surprises. And I think that has brought back into investors’ minds things that were not expected, that might lead to opportunities or threats: big risky asset rallies, performance of the FTSE – the world is moving faster, and investments need to be managed and adapted.”

In a world where even fund managers were taken surprise by Brexit and Trump, however, the question you must ask yourself is whether this expertise is worth the price.

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