Investors wanting to be more tactical, more nimble and more flexible with their portfolio allocation are buying index trackers in the current environment, according to Wei Li, head of investment strategy at iShares EMEA. 
There are a number of reasons investors may choose to buy passives, including (but not limited to) lower fees, increased liquidity and diversification, but an interesting trend this year has been for those begrudgingly investing in markets they do not fully believe in.
While this is not recommended by many, one example of this happening has been following the EU referendum in June.
As the below graph shows, equities immediately tumbled following the vote but bounced back to above pre-Brexit levels in the following months.
Performance of index in 2016
Source: FE Analytics
“From a sentiment perspective many economists and investors going into the referendum had the view that the outcome – had it been Brexit, which it was – would be negative for economic growth rate,” Li said.
“So when the result came out it was surprising to markets and yet not long after the Brexit referendum, we saw the market rallying back up to pre-Brexit levels.”
The FTSE All Share has risen 12.56 per cent so far this year, despite a more than 7 per cent fall in the immediate aftermath of the vote.
This has been led by a flight to ‘safer’ stocks such as the large international companies such as British American Tobacco and Unilever.
Another reason for investors being forced into equities was the rallying bond market, where yields have fallen to near-negative, and the Bank of England’s decision to slash interest rates to 0.25 per cent, increasing the opportunity cost of holding cash.
Performance of indices in 2016
Source: FE Analytics
Indeed as the above graph shows, UK government bonds have risen 15.92 per cent so far this year, far above the return from cash.
While many were concerned (and remain worried) that the rally is not backed up by fundamentals but more on sentiment, investors have wanted to participate regardless.
“The reality is that markets are going up and investors sitting on cash may find themselves missing out on performance and the stronger the momentum the stronger they feel this way,” Li said.
UK investors likely benchmark their portfolios against the FTSE 100 or another index such as the FTSE All Share, she says, and will underperform if not participating in the rally.
“When markets are running away from your underweight position investors feel compelled to participate in order to make up for the performance and the ETF [exchange traded fund] has been a great way to get quick access to markets,” she added.
Additionally, with the Brexit vote occurring in the summer, there was generally less bond issuance, meaning ETFs provided a convenient way into the market.
“If you think about the quiet summer times, issuance for investment grade has been lower so when the issuance has been lower there isn’t a huge amount of bonds available for investors to buy and if they want to be a part of the market they use ETFs,” she said.
One of the reasons ETFs give investors security is their easy to understand construct. Essentially, they do what they say on the tin.
“What has also made ETF popular is the fact that it’s very transparent, especially for physically-backed ETFs,” Li said.
“If you have an ETF where the FTSE 100 is the benchmark you can be reasonably assured that at the end of the year your returns are not going to be far from the return of the FTSE 100 plus or minus the management fee.”
Exchange traded funds have been extremely popular this year, with flows of $39.8bn across the globe registered last month alone, with around $26.7bn going into equities.
Li says more and more investors are using passives, but they still have a long way to go before becoming the norm.
“Having said that, the runway for ETF growth is still massive if you think about the fact that the ETF penetration rate versus the underlying market remains low for both equity and fixed income,” she said.
“Investors assume it is a large part of the market and it’s not. Globally equity ETF represents about 3.5 per cent of the underlying equity market which is very low considering the fact that ETFs are so liquid.”
“And it’s even less in fixed income. Fixed income ETFs represent about 0.6 per cent of the underlying bond market and given how liquid they have become it sometimes comes as a surprise for investors.”
While ETFs have seen a significant uptick this year, Li caveats that they should still be considered alongside active funds as part of a balanced portfolio.
“Instead of saying ETF versus active we have always been using the approach that is passive alongside active,” she said.
As the below graph shows, a top quartile active fund has significantly outperformed the market over three years.
Performance of indices and funds over 3yrs
Source: FE Analytics
As it should, over three years, the almost £9bn BlackRock UK Equity Tracker (which has a five crown FE passive fund rating) has performed very similarly to the FTSE All Share, returning 18.52 per cent.
Meanwhile, the average active fund, as shown by the IA UK All Companies sector, has returned 19.10 per cent.
The top quartile performing Newton UK Opportunities, for example, is benchmarked against the FTSE All Share and has returned 45.10 per cent over the period.
However, the chart also illustrates how active funds can leave investors with returns significantly below the market’s. M&G Recovery has made a 1.94 per cent loss over the same period.
“There are always going to be reasons why active plays a role in portfolio management and there are always going and reasons why ETFs play a role in portfolio management,” Li said.
“What we have seen so far in recent years is a lot of investors have adopted an approach where they go after the best performing active managers and at the same time try to bring down the overall costs of the portfolio by using passive instruments on the other side of the spectrum.”