The Financial Conduct Authority’s (FCA) scathing review of active management may be an attempt to bring down charges for clients, but could end up just pushing investors down the passive route.
The regulator certainly pulled no punches in its interim findings, published last month, saying actively managed funds overcharge and do not outperform their benchmarks after costs, while many are simply closet trackers.
Whether it was designed to or not, the FCA’s study is likely to increase the pressure to invest in passives, but wealth managers warn that this will likely introduce a new range of problems as an unintended consequence.
John Jackson, managing director of intermediary business at Cornelian Asset Management, believes that the rise in popularity of exchange-traded funds (ETFs) and trackers, which now hold 23% of industry assets, is already having an impact on the fund selection process.
‘When making individual investment selections in our active range our investment team is very conscious of the costs,’ he said. ‘They are always aware of the additional cost in purchasing active managers so they set the bar high to ensure they get value for money. This certainly does not prevent investing in active funds, but does introduce a useful rigour in selection.’
Cornelian last month launched a suite of risk-managed passive funds to sit alongside its existing multi-asset range, which it can offer at a lower cost, but backed by the same investment process.
Jackson said he was surprised that discretionary fund managers’ ETF-based model portfolios, which are widely available on a host of platforms, avoided closer scrutiny in the FCA’s study. He feels that there is a danger that investors opt for lower cost variants that only rebalance quarterly or even less frequently, effectively missing out on the benefits of true active asset allocation, which he deems a false economy.
‘The buyer of a model portfolio is compromising on the activity of the asset allocation – where it matters most. Whereas the buyer of an actively asset allocated fund buying passives retains the important active asset allocation but is reducing overall costs by using mainly passive instruments within it,’ he said.
‘As we believe that the greatest value derives from the overall asset allocation it makes perfect sense to ensure that this is where the investment in active management should be focused.’
Caroline Shaw, head of fund and asset management at Courtiers agrees, stressing that holding passive vehicles does not necessarily make a wealth manager passive in their approach to investing.
‘We are big believers in the passive route, but we would never describe ourselves as passive because we have an active asset allocation policy - we just choose to execute many of our positions using passive index replication. That doesn’t make us passive,’ she said.
‘This is particularly relevant for multi asset and global funds where a macro/overall decision must be taken (and this decision is not a passive one). I think it is important to make the distinction.
‘If a UK equity manager is FTSE 100 hugging then you could argue they are not making any calls so shouldn’t be charging for it. But if a global manager is using passive products to execute decisions but is making some big calls on allocation i.e. Europe vs US or similar then they are not passive, despite their use of, say, ETFs within the portfolio.’
Sceptics will point to the FCA’s finding that persistency of outperformance is minimal, with only 14.2% beating their benchmark over three years. Added to that, 42% of funds have such a low tracking error that they can be considered closet trackers with little value added, the regulator said.
Despite this, the regulator found that active funds levy an average annual management charge (AMC) of 0.9%, compared to 0.15% for their passive counterparts, but with no discernible performance premium.
The use of passives by wealth managers has already steadily risen, with Wealth Manager’s Top 100 survey providing a unique insight. Our top 100 fund buyers held 14.4% in passive vehicles back in 2014, but this rose to 22.2% in 2016 (see pie charts).
Ben Seager-Scott, director of investment strategy & research at Tilney Bestinvest, expects this trend to continue, but stressed that passives have their own nuances that investors need to understand.
‘Due diligence is important for passives just as much as active funds, but a number of the details are different, and we see this in some of the regulatory output recently around vehicles such as ETPs,’ he said.
Some believe that although professional investors are increasingly using passive funds in their asset allocation, the rate of take-up is too slow and is likely to be hastened by regulatory action, however.
Stephen Tu, vice president and senior analyst at Moody’s, points to the US example, where new rules on fiduciary responsibility mean advisers must ensure investments are in the best interests of clients, rather than merely suitable, and he expects this to extend globally.
‘It will become more difficult for advisers to place their clients into higher-cost and more complex investment products. Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interests and minimize fiduciary risk,’ he said.
‘The legal risks are highly significant in the new regulatory regime and will impose a higher bar on new sales of more expensive actively managed funds to retail investors.’
Whether the FCA will be so stringent remains to be seen, but active management fees will remain under spotlight and if the industry does not move to reduce them, few would rule out some form of market intervention down the line.