Investors shouldn’t base their investment in passives purely on low costs and strong performance in a bull market, according to Victoria Hasler of Square Mile Investment Consulting & Research, as the amount held in passives continues to rise. 
The growing popularity of passive strategies in recent years has put increased pressure on active fund management costs. In addition, investor sentiment and confidence in actively managed funds has come under stress due to underperformance by top managers more recently.
For example, the S&P 500 is a notoriously difficult market for fund managers to outperform given how efficient and well researched it is.
Performance of S&P 500 versus IA North America sector
Source: FE Analytics
As the above chart shows, over the past 10 years the average IA North America fund has significantly underperformed the index, returning just 259.05 per cent compared with a 310.57 per cent gain for the S&P 500.
Nevertheless, Hasler (pictured) said the trend towards passives seen over the past decade – cannot carry on “forever”.Over the past 10 years, assets held in tracker funds have grown from £30.7bn in 2009 – or 6 per cent of the industry total – to £218.3bn and 17.3 per cent of the industry total, according to data from the Investment Association.
Tracker funds under management since 2009
Source: Investment Association
“I worry slightly that a lot of people have gone into passives,” she said. “Retail investors who maybe don’t know that much about funds and markets and have gone into passives because they see them going up and up and up and think ‘well, that’s the best place to be then.
“And yes, a lot of passives have beaten active managers, so it seems like a no-brainer. But when markets turn that’s when they could get really spooked because then the passives will fall in line with the markets, and probably a bit more than the markets if you’ve got fees to take off.”
She added: “If you go into markets thinking that they just always go up and then they fall a lot, the worry then is that people just come out of the markets completely and think that investing isn’t really for them. And that would be a real shame.”
When markets do start falling that might be the time that active management will really become important, said Hasler, and where managers can prove their worth.
If a “good active manager,” gets just 55 per cent of their investment decisions right “they’re probably going to beat the benchmark”, said Hasler.
“So, there is scope for active managers to add value, but when they really do come into their own is when markets start falling and being able to protect on the downside,” she added.
Costs do remain a sticking point for many investors, however.
A survey of 26 industry participants by Square Mile – including fund managers, asset managers and global financial institutions – found that passive’s popularity was putting costs under pressure.
“Given the backdrop of the market over the last 10 years if markets are driven by beta why wouldn’t you buy a passive?” said Hasler. “It’s a cheap way to get access to the market.”
As such, some fund houses have already begun responding to the pricing battle with passives as Hasler highlighted Kames Capital and Artemis reducing their fund fees to a more competitive level.
“Kames just reduced their pricing across their 60 income funds quite considerably actually a few weeks ago, by about 15-25 basis points across their range,” she said.
“Artemis recently launched a corporate bond fund which they’re priced at 25 basis points AMC [annual management charge]. So [it’s] really quite aggressive pricing and actually not that far away from passives.”
Investors are willing to pay higher fees for actively managed funds, however, but only for those tha generate alpha and can prove they are generating alpha, said Hasler.
“They’re not prepared to pay for closet trackers and not prepared to pay for funds which consistently underperform,” she explained. “That sounds really obvious but at the moment there are loads of people who do pay for those kinds of funds.”
Ultimately, however, Hasler said passives are here to stay and do serve a purpose, when used appropriately and correctly.
“You don’t just buy passives for the sake of buying passives,” she explained. “You look around and if they’re the best option then absolutely buy a passive – it may well be that the best option is a passive in certain markets and at certain times.
“I’m definitely not saying ‘don’t go passive’, but I think that you do have to think about it rather than just going blindly into it,” Hasler concluded.