The debate surrounding active and passive funds is unlikely to go away any time soon, but there are signs that the landscape is shifting.
Investors turned on passives in a big way last month with more than £709m net outflows, the highest amount on record, data from Calastone found, with active funds remaining popular.
These outflows were a reversal in investor sentiment which have been incredibly bullish on index funds previously. In response Trustnet asked whether this was a start of the trend reversing or just a blip in passives’ popularity.
During the previous bull run in equity markets passive funds’ popularity grew as investors sought out cheaper ways to access an essentially one way market.
But now that environment has changed dramatically since the Covid-19 sell-off, as rising interest rates and inflation become a new reality. This has made markets more challenging to navigate and more volatile, sending indices and the passive trackers on a bumpy ride.
Many investors may have turned to active management to navigate the post-Covid market and the mounting headwinds. However it is not that simple. In light of this, two strategists outline the bull and bear case for index tracking.
Bear: There is now a change in market regime
Kelly Prior, investment manager in the multi-manager team at BMO Global Asset Management, said the current market seems to be supportive of active management over passsive.
"By building a passive portfolio based upon a straightforward blend of equities and government bonds over the past 10 years or so is likely to have resulted in impressive returns," Prior said.
"However, there is now a change in market regime as the power of quantitative easing has faded and inflation is building. Given the changing environment, will this evolve into a more fruitful one for active managers that had struggled to make headway against market momentum?
"We’ve heard from managers time and again about the latent value in their portfolios and the opportunity they’ve had to bolster quality in the sell-off post Covid-19’s emergence.
"As 2020 progressed many felt their portfolios to be well represented in quality businesses set to prosper as the situation improved. These weren’t just marketing soundbites with many buying into their own portfolios confident that value would be realised at some point.
"The vaccine announcements that began to emerge in November 2020 provided investors with the injection of confidence they needed. Risk assets reacted positively and with the road to normality becoming clearer it became a better environment for active management. Why? Because a handful of large stocks no longer dominated returns, investors began to refocus on fundamentals, and the attractions of ‘value’ were readily apparent.
"We’ve seen a broad-based return to form for many managers across our portfolios benefiting as ‘growth’s’ dominance subsided. Style trends aren’t the only story, however, as the merits of bottom-up fundamental investing begin to reassert themselves. We’ve also seen other holdings benefiting as market leadership becomes less concentrated and the qualities of individual businesses become recognised.
"To us the answer – as it always is – is all about balance. The current environment looks supportive for active. Sure, there will be times when themes can overpower some of these principles, but eventually they will bear fruit."
Bull: It is natural to expect ebbs and flows
Mark Fitzgerald, head of product specialism in Europe at Vanguard, said despite the short-term dip in flows towards trackers, the long-term trend seems to be firmly in favour of passive investing.
"Over the past decade investors have increasingly voted with their feet, moving from high-cost investment products to low-cost ones. Index investing, which is fundamentally a means of holding balanced, diversified portfolios at a very low cost, has been one of the beneficiaries of that broader trend. Consequently, index investing has largely become part of the norm for many investors, professional and retail alike," Fitzgerald said.
"As index investing matures, it is natural to expect ebbs and flows in the short term as investors react to different market conditions and macro events.
"The simplicity and low-cost effectiveness of broad-based index strategies lend themselves well to long-term, disciplined, diversified, core investment positions and as such we expect index products to continue to be popular with an ever growing band of investors.
"Looking at the persistent trends across different client types, segments, and products, in regard to our own experience, Vanguard LifeStrategy funds, composed of low-cost index building blocks, have been in the top 10 best-selling funds list in the UK each month for the past five years.
"Similarly our UCITS ETF range has maintained strong and steady flows month on month, year on year. In short, we can see a clear preference in many cases for index strategies that can be held over the long term.
"This long-term point is key. Nobody can see around corners, and the evidence is clear that investors have the best chance of investment success by having a clear goal, designing a portfolio with the correct asset allocation to achieve that goal, and then holding it for the long-term at a low-cost.
"Whether they wish to implement their portfolio through index or active strategies is a matter of investor’s risk tolerance – are they willing to risk the chance of underperformance for the possibility of outperformance - and not particular market conditions."