Passive investing is more popular than ever but research by Natixis Investment Managers suggests many investors still have “critical misconceptions” about this approach.
The past decade has been marked by a significant shift away from active management and towards passive, as investors allocated to low-cost index trackers in the midst of an almost relentless bull run.
A report from the Federal Reserve Bank of Boston earlier this year said passive funds accounted for 37 per cent of combined US mutual fund and ETF assets under management at the end of December 2017. This was up from 14 per cent in 2005 and 3 per cent in 1995.
That paper highlighted that several factors have combined to support the shift from active to passive.
AUM of active and passive strategies of overall UK managed assets
Source: Investment Association
“The development of the efficient markets hypothesis in the 1950s and 1960s called into question the role of active selection of securities to ‘beat the market’ and indicated that investors should hold the market portfolio itself. The introduction of the first stock index funds in the 1970s made passive investments in the market portfolio a practical option for retail investors,” its authors wrote.
“The relatively lower costs associated with passive investing and evidence of underperformance of active managers have probably contributed, as well. Another factor is the growing popularity of ETFs, which are largely passive investment vehicles. Finally, greater regulatory focus on the fees of investment products may have encouraged the financial industry to offer low-cost, passive products to individual investors.”
Although the above figures relate to the US market, the move towards passive management has been a global trend. In the UK, some £194bn of the Investment Association universe – or 15.4 per cent – is held in index trackers while billions more is invested in ETFs.
Against this backdrop, the Natixis Investment Managers polled 9,100 private investors in 25 countries to gauge their understanding of passive investment.
“Since the crisis, the virtues and shortcomings of active and passive investing have shown up front and centre in the financial press and cable TV. It appears that investors may have only heard part of the story,” Natixis said.
“In many cases the dialogue has focused on fees, leaving investors with an incomplete understanding of what passive investments can provide and what they cannot. While 83 per cent of investors say fees are an important consideration in selecting investments, many may be confusing these lower fees with greater value.”
The research found that two-thirds of private investors say they understand the difference between active and passive investment. Further questions suggest this is the case, to some extent: 71 per cent understand the basic premise that passive investments give them market returns while 57 per cent recognise that passive investments have lower fees.
However, Natixis added that while investors may understand this basic argument for passive investment, they also appear to be guilty of seeing a lower fee and taking this to mean index funds have much greater advantages than passive investing can deliver.
Source: Natixis Investment Managers
“Six in ten investors worldwide (63 per cent) believe index funds are less risky. They’re not. Index funds have no built-in risk management. Investors’ assets are exposed to the same level of risk that’s presented by the markets at large,” the report said.
“Two-thirds of investors also believe passive investments will help them minimise losses. They can’t. Investors may get the gains when markets are up, but they also get the losses when markets are down.”
The survey also revealed an irony in private investors’ thinking about passive: while many “extol the virtues” of passive investment, 72 per cent told Natixis that they prefer to have an expert find the best investment opportunities in the market while two-thirds expect funds to have a portfolio that looks substantially different from the benchmark.
What’s more, three-quarters think it is important to beat the benchmark when investing – an outcome that is impossible with passives – and nine out of ten said they want to be protected from volatility, which again can’t be delivered passively.
James Downie, head of institutional asset consulting at MitonOptimal Group, makes the argument that investors need to understand that there is no true passive investment as an active decision will have to be made at some point. Investors should stop thinking of themselves as being passive, therefore.
“Active investing is easy to define. It is the style of an investment manager to take active bets away from a particular index, investing more in what he or she believes to be cheap shares and less in expensive shares in an effort, over time, to beat that index net of the active fees charged for being so clever,” he said
“Passive, on the other hand, implies that both the investor and the investment manager are lying back and doing nothing and waiting for something to happen. It couldn’t be further from the truth.”
Downie gave the example of an investor who understood the challenges that active managers face in the US market so decides to take a passive approach. However, they then realise that there are literally dozens of ways of defining ‘the US market’: four of the most popular are the Dow Jones, S&P 500, Nasdaq and Wilshire 5000.
Source: MitonOptimal Group
“The investor is now thoroughly confused as the US share market appears to perform very differently depending on which index one chooses as one’s ‘passive’ vehicle,” he continued. “One-year returns vary from 2.7 per cent to 5.3 per cent, three-year returns from 10.1 per cent to 13.8 per cent per annum and five-year performances from 9.7 per cent to 14.8 per cent per annum.”
Of course, the Nasdaq index of IT and tech shares and so can be explained away as tracking a different basket of shares to the others. The Dow Jones Index tracks an equally-weighted basket of the largest 30 shares on the New York Stock Exchange, the S&P 500 is the index that reflects the largest 500 shares weighted by market capitalisation and the Wilshire 5000 the largest 5,000 shares by market capitalisation
“So, the passive investor has to make an active decision about which index to use and there are literally thousands of them that mirror different parts of the market, different numbers of shares, different styles of investing and different sizes of shares to mention a few,” Downie said.
Even if the investor decides to avoid this decision by simply tracking the global equity market, they will still have to choose between indices that deliver different results. For example, the FSTE All World index has made 250.03 per cent over the past 10 years while the MSCI AC World is up just 229.69 per cent.
“In reality, there is no such thing as passive investing,” Downie concluded.
“The correct term is an ‘index-tracker’ and the investor needs to do substantial homework to understand which index should be tracked and the expected returns. The market should forget the term ‘passive’ as index-tracking requires specialist techniques and choosing them requires active choice.”