Do you think a specific market is overvalued? Are you looking for low-cost index replication? Are you worried about Brexit and the potential for UK active managers to underperform?
If that is the case, you may want to consider an index mutual fund over an actively-managed investment vehicle, according to Square Mile Investment Consulting & Research’s Tom Poulter and Paul Angell.
Passive strategies have become a common tool to access highly-efficient markets such as the US – where outperforming the S&P 500 index through expert stock selection or market timing is known to be harder than in other markets.
Helped by an environment of synchronised global growth and positive returns seen over the past few years, exchange-traded funds (ETFs) and index-tracking mutual funds have also seen an increasing demand by those investors worried about fund charges.
Indeed, the amount invested in passive strategies has increased from 17 per cent in 2008 to 26 per cent in 2017, according to data from the Investment Association.
Active and passive strategies as a proportion of total UK AUM
Source: Investment Association
However, just focusing on charges when deciding between active and passive could be a dangerous thing to do.
Instead, several factors must be considered to make the right investment decision.
“For us, it is about what the investor wants: do they want low-cost and market returns? Then invest in passives,” said Angell, an investment research analyst at the research firm.
According to the pair, the question on whether choosing active or passive doesn’t have a straightforward answer but, ultimately, is down to the outcomes investors are looking for and the markets they want to access.
US equities, sterling corporate bond or the FTSE 100, for example, are areas where investors may be better off in passives.
“We do have money in a US-equity passive and some in sterling corporate bond,” said Square Mile’s head of quantitative research Tom Poulter.
“We are okay with US and UK passives. We have corporate bonds – we do rate them – but investors have to be aware that there can be certain times, like now, when the markets are overvalued,” he said.
“And, if you think there is going to be a recession you probably want to go active.”
As the pair noted, passive funds are good tools to access broad asset classes such as US or UK equities. In the case of more niche asset classes, it will depend on several aspects.
“Corporate bonds and emerging markets are the markets where at certain times passives can be good and at certain times they can be a bad option,” Poulter pointed out.
“You have to be risk-wise in the UK, especially in the 100 companies listed on the London Stock Exchange with the highest market capitalisation.”
Funds under management of passive fund by index investment type
Source: Investment Association
As Poulter and Angell agreed, although there can always be ‘Carillion cases’ the chances of having one of the 100 biggest companies in the UK being liquidated and removed from the index or the portfolio are “generally low”.
“The way we manage our models is, we do have a US equity passive fund because is a very efficient market that active managers struggle to outperform. The US tends to be held pretty widely via passive exposure in the UK,” noted Angell.
“We have a similar view on sterling corporate bonds. You get the low cost: these passive funds charge 15 basis points versus a 75 basis points charge for active and, if you are not convinced that the active managers are actually going to add value then, you should go for the cheaper option.”
Another time when investors may be better off in passives, the pair noted, is when facing uncertainty about markets performance going forward.
The UK divorce from the EU is an example of situation where they the team has decided to allocate some money to UK passives.
“If you are unsure of the markets you may as well buy a passive. In the UK we have some money in passives because, obviously, with Brexit no one knows what is going to happen and we have to hold certain amount of equities,” said Poulter.
“The active managers could easily underperform as much as they can outperform so, if you just take the market return is always quite good and at least you avoid the high cost.”
However, he warned, investors shouldn’t underestimate the risks associated with passive investing. While many see these are risk-free tools, there are certain circumstances where active strategies prove to be more resilient.
“A lot of people think passives are risk-free, but they are not. If UK equity markets fall, you are going to fall,” said Poulter.
Angell added: “The only risk you can avoid is the risk of underperforming your benchmark if you pick the right one.
“When markets go down, there is nothing a passive manager can do apart from holding the stocks. Even if one of them is a serious sell, an active manager can easily go and sell it.”
“Active versus passive is not a binary call. A portfolio that carefully blends active and passive funds can provide investors with the best potential outcome.
HSBC FTSE 100 Index, iShares 100 UK Equity Index, L&G UK 100 Index Trust are some of the index funds the team rates have recommended in their preferred list of funds
Rolling one-year r-squared ratio of L&G UK 100 Index Trust vs FTSE 100 over 12mths
Source: FE Analytics
L&G UK 100 Index Trust is £934.9m in size and has an OCF of 0.10 per cent, which, according to the team at Square Mile is considerably cheaper than the median for passive funds in the UK equity tracker sector.
Over one year, the L&G fund has an r-square figure relative to the FTSE 100 index of 0.85, according to FE Analytics, with a figure of 1 representing perfect correlation.
“Over the long term the fund has reasonably tracked its benchmark, therefore we believe that the fund represents very good value for money,” the firm noted.