Passive shift

With passive investing reaching record levels, the Review Consultant Editor Andrew Davis examines why passive vehicles are growing in popularity and looks at the relationship between active and passive investing

In a highly uncertain world, one of the few things investors can be sure of is that the flow of funds into passive vehicles is going up. Figures compiled by BlackRock show that during 2014, a record $330.6bn was invested in Exchange Traded Products (ETPs), compared with $236.1bn in 2013. Meanwhile, a new report by PwC forecasts that total assets in ETPs will grow from $2.6tn today to at least $5tn by 2020.

Similar things are happening in the related field of index trackers - essentially, mutual funds that replicate an index but, unlike ETPs are not tradable on a stock exchange. The biggest provider in this market, US-based Vanguard, announced in early January that it attracted net inflows of $243bn in 2014, a 61% increase on the previous world record for asset gathering, which Vanguard set in 2013. 

It is clear, then, that passive investing is enjoying huge momentum among all types of investors, particularly in the US but increasingly in Europe and elsewhere. This trend signals new challenges, both for investors and the fund management industry. As the share of assets managed passively continues to grow, how should investors decide between, or blend, active and passive strategies in their portfolios? And how can managers stake out a clear proposition that will keep them relevant?
"In terms of truly active funds, maybe 45% would be decently active, another 22% passive and the rest closet trackers, which is obviously not a great state of play" At the heart of the relationship between active and passive investing lie the concepts of beta and alpha. Beta signifies the return provided by the market and therefore the return you can expect (less fund management fees) by investing in a passive vehicle that tracks that market. Alpha signifies anything an active manager creates over and above the market return by selecting a particular subset of the stocks that make up that market. 

Double incentive There are at least two key reasons why investors are becoming increasingly focused on the merits of passive management.

First, growing awareness of the role that fees play in determining overall returns has encouraged investors to seek lower costs, which tends to benefit passive providers. Second, there is an increasing belief that it is all but impossible to beat the market consistently and that most investors are therefore better off simply attempting to track it as cheaply as possible.

The record amount invested in ETPs in 2014

What total assets in ETPs will be worth by 2020

The world-record amount Vanguard attracted in net inflows in 2014

Sources: BlackRock, PwC, Vanguard
A common response to the dilemma of active versus passive has been for institutional investors to move to 'core' holdings of passive funds with an 'overlay' of actively managed funds in order to increase their exposure to certain areas by working with selected managers. This might mean investing in major market indices through passive vehicles and adding active exposure to smaller, more illiquid or more idiosyncratic assets that are less suitable for a passive strategy. Or it could mean adding active funds that have particular styles, such as a value-focused approach.

However, the practical difficulty that faces many retail investors is that they cannot always be sure what they are paying for - active alpha or market-based beta. In particular, if the actively managed fund they are investing in has almost the same holdings as an index tracker, but the higher costs that go with active management, then they are effectively paying for alpha but getting beta. 'Closet tracking', as this is known, helps active managers avoid the risk of underperforming their benchmark, but it tends to produce less-attractive returns for their investors because it has higher fees than the passive equivalent. 

Active analysis One way of judging whether an active fund is genuinely active or just a closet tracker is to look at the extent to which its holdings differ from its benchmark index - its 'active share'. Simon Evan-Cook of Premier Asset Management published research on active share and closet trackers in the UK funds industry last November. He split actively managed funds in various sectors into four groups according to how high their active shares were. Funds scoring 0-15 out of 100 differed very little from the index, while those scoring 80+ were very different and therefore 'highly active'. He classed any fund scoring 15-60 as a closet tracker; funds scoring 15 or less were regarded as true index trackers. 

"If you look at the main UK equity sectors, in terms of truly active funds, maybe 45% would be decently active, and you'd probably have another 22% or so that are passive, and the rest would be closet trackers, which is obviously not a great state of play," he says. "But in other sectors, such as Japan, the picture is different and you just don't have that same body of closet trackers."

Evan-Cook argues that the worst examples occur in the mass-market products sold to inexperienced retail investors. He calculates that there is £58bn in UK equity funds that are closet trackers, and that these investors could save more than £750m a year in fees by switching to the cheapest tracker. 

He also calculates that over the past ten years, UK equity funds with active share scores of 80+ have produced annual returns of 10.3%, true trackers have returned 7.8% a year and closet trackers 7.6% - the difference between the latter two largely down to closet trackers' higher fees. 

Winning strategy? So how useful is active share as a way of picking winning fund managers? Logically, portfolios with high active share differ the most from a benchmark and therefore have the highest chance of beating it - as well as the highest chance of underperforming it. The only thing one can be sure of is that very idiosyncratic portfolios will have a wider range of possible returns than those that stay close to the index.

However, using active share as a way to filter out active funds that closely resemble an index is a useful way of paying for alpha but getting beta. The problem is that UK funds are not currently obliged to publish their active share scores, although regulators in Scandinavia are mandating this, according to Andrew Clare, Nick Motson, Richard Payne and Steve Thomas of Cass Business School, authors of the influential recent paper on fund management charges, 'Heads we Win, Tails you Lose'.

Beyond that, the ability to use high active share as a way to identify winning managers is limited. As the Standard & Poor's (S&P) Persistence Scorecard: December 2014 shows, very few managers manage to stay at the top of the performance tables for any length of time. Less than 1% of large-cap mutual fund managers were still in the top quartile at the end of S&P's five-year measurement period. "This figure paints a negative picture regarding the lack of long-term persistence in mutual fund returns," the study observes.

Given that active share scores are unlikely to be able to predict which managers will outperform consistently, this approach is not on its own a silver bullet for those seeking successful active strategies, although it can help to weed out expensive 'quasi trackers'. Equally, even a fully passive strategy will require active decisions about relative allocations to different asset classes. The debate over how to combine active and passive approaches still has a long way to run.
Published: 28 Jan 2015
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