Investors should guard against complacency when investing in passive vehicles, according to industry experts, as a market crash could derail markets quicker than some may anticipate.
Markets have been on an unprecedented bull run since the financial crisis in 2008 with most indices rising consistently in each of the last eight years.
In the UK, the FTSE 100 index continues to march on to record highs, up 63.82 per cent over the past decade and eclipsing the highs seen in 2007 before the financial crash.
Performance of index over 10yrs
Source: FE Analytics
Andy Merricks, head of investments at Skerritts, said: “The growth in passives – be they geographic, sector or ‘smart beta’ factors – is a symptom of a long bull market where everything goes up.
“Complacency is a dangerous characteristic in investment management and it looks like the majority are displaying it by the bucket-load.
“Nowhere is this more evident than in some of the ‘passive equals best’ opinions that are swirling around our industry with ever-greater conviction.”
The adviser said he does not think that passive investments are bad – far from it – but that investors may have become too accepting that these vehicles are inherently better than active management.
He explained: “Too many people are almost evangelical over their passive versus active positions and criticism of trackers is viewed as heresy.
“Say a bad word about passives and you’re labelled an old-fashioned practitioner who has somehow failed to ‘get it’ when it comes to modern portfolio construction.”
He said investors appear to have forgotten the market crashes of 1987 and 2000 (as well as the most recent in 2008) and overlooked what losing 40 per cent of their capital can feel like.
“Today, we seem to have forgotten all over again that a crash can exceed all expectation,” he said.
“Several professionals that we’ve spoken to recently speak glibly of expecting a correction sometime soon – of 5 per cent or so. That’s not a correction. It’s normal.
“But this long bull run since 2009 has anaesthetised expectation to such a degree that the reality of seeing nearly half the value of your capital wiped out before your very eyes has been dismissed as fanciful doom-mongering,” he added.
Essentially, Merricks said, by buying into a passive instrument investors are buying an assortment of stocks without any consideration given to underlying valuations.
“It doesn’t matter to the passive investor about the price that they are paying for what they are buying, except ironically it is the low cost of the product that they are buying that tends to attract the more favourable comments,” he said. 
“The fact that they may be paying relatively little for something that is stuffed to the brim with over-valued assets seems to get lost somewhere.”
Merricks (pictured) added that another growing risk in this mature bull market is that some indices are restrictive, meaning the weight of money coming into them is making it difficult to find enough stock to satisfy demand.
“Apart from this clearly inflating prices artificially into bubble territory, it is causing some indexes to be expanded so that the money coming in does not actually buy what it thinks it is as other stocks are included in the index purely to provide liquidity,” he said.
“Liquidity and capacity sometimes get confused, but it is this capacity issue that will make the liquidity issue that much more difficult should the queue of buyers turn into a queue of sellers.”
As such, he predicts a major correction in the ETF market to take effect in the not-too-distant future.
“You don’t need the eyes of Nostradamus to foresee a major blow-up at some point in the ETF market,” he said.
“We buy ETFs. We like ETFs. We think that ETFs are a majorly beneficial tool to have in one’s investment arsenal, but as with anything that can go up in value, it can head the other way rapidly if a storm breaks, and it cannot be overstated how important it is that you can escape in a timely and orderly fashion should you need to do so.”
Ben Willis, investment manager at Whitechurch Securities, also uses passive investments to gain exposure to certain areas of the market in a cost-effective way.
However, Willis said the surge in passive inflows is also causing problems, as it can produce inefficient allocation of capital.
“For example, if you keep buying headline index trackers, capital flows continue to reward the largest positions within market which make up the index constituents,” he explained.
This has been witnessed, to a certain extent, in the US, where investors have fled to higher quality growth stocks and passive investing is much more prominent. Here mid- and small-caps have struggled to outperform as the allocation capital has trended towards the higher end of the market.
Similarly, in the UK, investors who sought out passive vehicles outperformed as many active managers – who typically had an overweight to mid-caps – struggled.
Performance of indices in 2016
Source: FE Analytics
However, Willis said UK investors with overseas exposure should bear in mind that sterling weakness significantly boosted returns.
He said: “For example, an UK investor buying a TOPIX tracker fund would have got returns of over 20 per cent last year in sterling terms. However, in local currency terms, the TOPIX was flat over 2016.
“Is sterling weakness going to contribute such a tailwind in 2017? With lots of global equity indices reaching or nearing record highs, valuations of headline indices are looking relatively expensive.
Performance of sterling vs dollar
Source: FE Analytics
“There is value opportunities within markets and asset classes, but I think investors may need to consider paying-up for some active management in order to unlock it.”
David Coombs, who runs the Rathbone Multi-Asset Portfolio funds agreed, adding that while active management has “developed a serious image problem” the rise of passive investing has forced it to up its game.
“Passives have enjoyed ideal conditions since the financial crisis, as broad political consensus and easy money have supported highly correlated markets. But the tables are turning towards active management again,” he said.
“The Brexit vote, Trump’s victory and more polarised party manifestos in the UK have closed a period of political harmony and created new challenges for markets.
“In addition, emerging demographic trends and disruptive technologies are rapidly blotting the landscape. When it comes to asset allocation within multi-asset portfolios, therefore, we believe active managers are more likely to protect and grow capital.
“How can you overcome the intricacies of a new world order with a ‘blunt tool’ passive investment vehicle?”
He said that “an obsession with charges has led to an ambush of the active management industry” but added that it is equally important that active investing offers more than passive investing to justify these fees.
Coombs added: “This means allocating capital efficiently to those companies with the competitive edge and vision to grow their earnings, and holding management to account to do the ‘right thing’ for all stakeholders.”