The world’s biggest fund is passively managed. Is passive triumphing over active?

11th November 2013

For the first time, the largest fund in the world is a passive fund. The Vanguard Total Stock Market Index fund recently overtook the Pimco Total Return fund managed by veteran bond investor Bill Gross, to take the crown, as the Telegraph reports. It is a symptom of an increased preference for passive investment, rather than taking a risk on an active manager. What is creating the shift? And can it last asks Cherry Reynard.

In the UK, the popularity of passive funds is relatively easy to explain. First big passive firms, Vanguard included but also Blackrock and other ETF players are increasing their marketing spend to both direct investors and to financial advisers who then recommend their products. On the advised side, we have seen the implementation of the Retail Distribution Review in January of this year.

The new rules prevent financial advisers taking commission. This was paid on active funds, not passive ones. In payment terms, this has created a level playing field for active and passive funds.

Some advisers have always recommended passive funds. Indeed some do so just about exclusively but it is clear many more are only now warming to the idea. Passive funds, always the laggard, are now in the process of catching up.

Equally, there have been a number of high profile star fund manager departures. Neil Woodford leaving Invesco Perpetual and Richard Buxton leaving Schroders, may have tried investors’ patience with active fund management demonstrating that it is a fickle business. With passive funds, there is no risk the manager will leave.

Even though it is now relatively easy to switch, it means that investors have to make a decision on whether to stay, leave or find someone new and it adds complexity that many do not want.

The result has been a dramatic increase in the popularity of passive funds on platforms and elsewhere. As points out, passive providers Vanguard and HSBC Global Asset Management have seen a sharp rise in demand for their funds sold via platforms since the introduction of the RDR.

This may explain the shift to passive in the UK, but it does not explain the global popularity of passive funds? The defining consideration for many has been cost, but recent research by Morningstar suggests that passives may not be as  competitive on costs in the new ‘no commission’ environment. As this piece in the Financial Times says: “Passive funds … are starting to lose their competitive edge on prices as providers of actively managed funds cut their fees. In spite of ultra-low annual fees offered by the largest providers of passive funds such as Vanguard, Legal & General Investments and HSBC, research by Morningstar has found that on average, retail equity index funds have a total expense ratio of 0.73 per cent.

“By comparison Investec Asset Management’s new “clean” share classes for six of its most popular actively managed funds…come with an annual management charge of 0.65 per cent”, as reported.

Although performance figures can be sliced in a number of different ways, in many fund categories passives don’t win on performance either. The FTSE All Share is up 17.7% over the past 12 months. The average UK All Companies fund is up 24.9% and the average UK Equity Income fund up 24.2%. The US is a rare exception with the S&P 500 up 27.6% over one year, and the average fund up 26.5%.

Passives have certainly been beneficiaries of the shift towards asset allocation as a means of generating returns. Historically, the dominant thinking was that shifting between asset classes was notoriously difficult and therefore selecting between different funds was a better and more reliable way to generate returns.

This thinking has changed substantially. Charles MacKinnon, chief investment officer at Thurleigh Asset Management is typical of many wealth managers when he says, “asset allocation is the bottom line for us. We believe that getting the asset allocation right will determine the client outcome, rather than trying to make a choice between BP and Shell.” He points out that in 2008 being long on bonds and low on equities would have made a far greater difference to a client’s wealth than selecting between two bond funds.

He uses index funds for around a third of his overall holdings, saying that there are always times that index funds will do better simply because they hold stocks that no self-respecting active fund manager would ever hold – the National Bank of Greece for example, will have its day in the sun.

This shift in thinking also explains the proliferation of multi-asset and asset allocation funds. The Standard Life GARs fund continues to be wildly popular with investors who believe that asset allocation is a far greater predictor of long-term returns than fund selection.

There is perhaps one final reason why passive funds are seeing such popularity: their simplicity. This may be superficial – some synthetic ETFs for example are fiendishly complicated underneath – but investors at least know what they are likely to get from an index fund. They don’t have to try and understand an investment process, when and why a manager might do well and study the nuances of style and stock selection.

In every portfolio, there is undoubtedly a place for active funds and a place for passive funds. The current popularity of passive funds is partly catch-up, partly the current vogue to generate returns from asset allocation and partly their simplicity. However, the active industry is still challenging on price and performance. Such competition between the two schools of thought may be no bad thing.

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