Selected Issue 6 - Summer 2019

THE ROLE OF PASSIVE FUNDS There are numerous ways in which passive funds can be used within a portfolio: including active funds and possibly ETFs may be appropriate.

Removal of a risk element The performance of a good passive fund is unlikely to deviate much from its benchmark index and hence investors should not have to worry about the relative volatility of the fund’s performance in any market conditions. The volatility of the underlying index can of course deviate significantly depending on the prevailing market conditions. Client perception The concept of index tracking is relatively straightforward to explain, particularly for an adviser using a fund that ‘fully replicates’ an index. The client simply needs to understand the characteristics of the relevant indices in the knowledge that the performance of the underlying funds will pretty much mirror them. It does become slightly more complicated if the adviser needs to explain ‘stratified sampling’ or ‘synthetic’ trackers (more on these later) but whatever the vehicle, the concept is generally the same. Fewer surprises for the client If the adviser has explained the concept and dynamics of stock markets and the investor understands that the performance of their funds will be aligned to them then they should not get too many unpleasant surprises regarding performance. Investment conditions in recent years have provided many challenges to both advisers and investors alike but if an adviser has recommended an index tracker fund and explained to the client how this works then this will remove concerns over the potential ‘double whammy’ of underperforming funds in falling markets. Fully diversified exposure to a market where value is difficult to extract due to over research As discussed, a lot of academic research says that it is very difficult for an active manager to beat the index in an ‘efficient’ market because the amount of data and analysis available on each stock would prevent them from gaining a competitive advantage as the market price always reflects the stock’s true value. Passive funds therefore take one layer of the decision making process away (i.e. which manager can outperform) simplifying the investment advice process and arguably making it easier to manage the client’s expectations. Reduced research requirements Passive investors may argue that even if it was possible for an active manager to beat the market, the amount of due diligence required to find managers who can both consistently beat their benchmark within a fund that meets the client’s requirements is too costly and disproportionate to the overall benefit for the client. One could also argue that once a panel of passive funds have been established the ongoing due diligence required for each client review is significantly reduced as well.

Some advisers will not use passive funds to gain exposure to asset classes like corporate bonds and property and there may also be specialist funds whose objectives and mandates are difficult to replicate.

Exclusively A segment of the adviser market often build client portfolios exclusively from passive funds, with some firms/advisers using ETFs as well. These firms are likely to construct and monitor these solutions via wraps/platforms, particularly if they wish to trade in ETFs. These businesses will generally have taken the view that active fund management does not work and that it is more important that the client is invested in the right combination of asset classes at the right times. They will often use the output from a risk tolerance questionnaire and stochastic model or investment committee as a framework for asset allocation decisions, overlaid with shorter-term tactical adjustments to the model based on the firm’s views on the markets. The benefits to the end investor of this approach are low costs and relatively predictable performance characteristics. The adviser or firm should also save significant amounts of time both initially when constructing a portfolio and at each client review as there won’t be as much work involved in monitoring any over or underperformance. There will also be fewer worries around any changes to management, investment processes and other factors likely to trigger a review of a fund’s endorsement. A quick assessment of a passive fund’s adherence to its objectives via an analysis of performance along with tracking error and difference will generally suffice for reviews at a fund level. Proponents of passive investing would argue that with a lot less investment decision making to be done, much more time can be spent discussing a client’s ongoing requirements. Core to a portfolio Having carried out the relevant ‘risk assessment’ and asset allocation for a client some advisers will combine active and passive funds within a client’s portfolio. They will possibly use the passive funds as a low cost, low volatility (relatively) core holding, providing an opportunity to research and use higher alpha managers as ‘satellite’ holdings. Another way of combining the two approaches is to predominantly use passive funds to gain exposure to ‘efficient’ markets and active funds in ‘inefficient’ markets. This is because there is a belief among some advisers that it is difficult to outperform an ‘efficient’ market because so much information is available on each stock - and hence reflected in its price - that it is difficult for fund managers to find pricing anomalies and gain a competitive advantage. There will be a greater perceived opportunity for active managers to use the skill and the resource available to them to find value in ‘inefficient’ markets as theory suggests that stocks in some markets are not always accurately priced. This perception has been challenged and many active managers have failed to beat the index in many overseas/developing markets. Whilst there is a reasonable spread of index tracking funds, there may not be enough choice to be able to populate a model portfolio for instance, so the use of other vehicles

As a specialist play Passive funds, particularly ETFs, have

increasingly been used by advisers and many fund managers to gain exposure to a particular geographic area or asset. ETFs can provide very quick, cheap access to specialist areas and are very easy to trade. There are however, potential added counterparty risks to using some ETFs and many niche investments may be unsuitable for most retail investors. Disadvantages of passive investing There are disadvantages to passive investing. Most passive funds will marginally underperform their benchmarks; either because of tracking errors or fund fees/expenses. This could be frustrating for some investors when a cursory glance at the financial press reminds them that talented active managers can generate significant returns over and above the same index/benchmark net of charges. Passive investing is often not the most efficient way to gain exposure to some asset classes - corporate bonds and property are good examples. Simply put, a market weighted corporate bond index tracker would leave investors with higher exposure to the most indebted companies, as well as exposing them to underperformance through higher costs and relative illiquidity. To accurately track the performance of UK commercial property a tracker would need to own/part own potentially thousands of properties, which clearly is not feasible. Finally, with passive investing an investor may often end up buying shares in companies at historically high prices, if they enter the FTSE 100 for instance, and be forced to sell the same shares at very low prices if the same company subsequently falls out of the FTSE 100. Benefits of Passive Funds Exponents of passive investing will point to numerous advantages: Lower cost Passive/index tracking funds are generally cheaper than active funds and often by a considerable margin, although investors should seek to understand the ‘total expenses’ involved in owning passive funds and ETFs. Passive funds will often have a lead fund manager to oversee operations although there is very little human input to any decision making. Hence there is no need for investment committees to make stock, sector or geographic calls and no need for a large team of analyst to provide ideas for the fund manager. This means the overheads for running a passive fund, including trading activity, are much lower and this is usually reflected in lower annual management charges.

For more information please visit www.pruadviser.co.uk or speak to your Account Manager

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