What Investment: "Are passive funds a good idea?"

Charles Owen, founder and director at CoInvestor writes for What Investment on the advantages of taking a genuinely passive approach to investing.

Recent ‘big picture’ issues such as Brexit, Trump and rising concern over the Italian banking sector continue to create uncertainty against a back drop of increasing nervousness in the global bond market. This is rightly causing investors to consider the structure of their portfolios and, dependent on their attitude to risk, reshape them defensively or opportunistically.

This will be a relatively normal process in the way that many private investors manage their investments; most investments will be held via equity fund managers in an ISA or SIPP and then be monitored from time to time, with decisions to buy or sell made relatively infrequently in response to what investors see as macro threats or opportunities, or perhaps on a whim having read about a particular fund or manager in the financial press.

In behaving in this way these private investors would generally consider themselves to be passive investors. But this is a long way from being a passive investor. In fact it’s almost entirely active – and this is a problem. The funds that are being invested into are ‘actively managed’, meaning that a fund manager is being paid to buy and sell holdings in an attempt to outperform the market. On the whole they don’t achieve this.

Last month the Financial Conduct Authority (“FCA”) published an interim report on the Asset Management market and whilst all the fund managers will have read this report, all 206 pages of it, the chances are that very few private investors will even be aware of it, let alone have read it. They should.

Much of the focus of the report went to the heart of the ongoing argument between active or passively managed equity funds. The FCA didn’t hold back its punches; Many active funds closely track their benchmark and therefore offer similar exposure as passive funds but at considerably higher costs.

£20,000 invested in a passive fund over 20 years might earn c. 44% more than an investment in an actively managed fund assuming the same fund returns profile as a result of fees

Mainstream actively managed fund charges have remained broadly the same over the last 10 years whilst charges for passive finds have fallen over the last five years. The annual average disclosed fee for actively managed funds is 0.90% of AUM, six times greater than the average 0.15% for passive funds. This doesn’t account for transaction costs which are also higher for actively manged funds

As fund sizes increase, price does not fall meaning that economies of scale are captured by the fund manager rather than passed back to investors in the fund.

The FCA is not alone in starting to take a position on the asset management sector and the European commission is expected to recommend that EU regulators also investigate asset management performance and fees. It is highly likely therefore that the asset management industry will need to take action to address many of the issues highlighted in the report, or will be forced to do so by specific FCA regulations.

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