The lower cost of passive products has led investors to question whether long-only active managers can actually claim to provide value for money.
The fast rise of such products have exposed weaknesses in the system with a number of commentators highlighting the risk of redemptions from active funds.
'ETFs aren’t going away any time soon and active managers must evolve or die,' stated Jeremy Steinson, director at Patronus Partners.
'Managers who have reduced their fees and have adopted passive vehicles to implement their investment strategies are a healthy example of this evolution.'
He added: 'The growth in ETFs has been astonishing. Long-only active managers with higher fees must demonstrate added value, or risk redemptions.'
Alongside exposing closet trackers, the growth of ETFs has also helped highlight the issue of over-diversification in many private client portfolios, Steinson claims.
He explains: ‘Let us for a moment assume you want to take an active approach to investing. You select an active fund which fits the bill, but you worry that the fund you’ve picked may be a dud and you expand your selection to ten active funds, to diversify your manager risk; so far, so good.’
This, however, is where Steinson says it becomes problematic. He states that if the investor considers their overall positioning, they may realise that where one fund is overweight, another one will be underweight.
‘The net result of your diversified portfolio of active funds is a passive outcome but with an active price tag,’ he added. ‘You are actively passive.’
Echoing Steinson, Peter Sleep, senior portfolio manager at Seven Investment Management, commented: ‘Buying lots of active funds is not logical.
‘You will probably end up buying the market and eliminating any chance of outperforming the market and you will lock in those high fees.'
He noted that there is a lot of research which suggests an active manager’s returns come from a few stocks and the rest detract value.
He said: ‘Andrew Carnegie said: "put all your eggs in one basket and then watch that basket". Carnegie did this with the US steel industry in the 19th century and did very well and it seems, with big caveats, active managers should think about a similar approach.’
Sleep’s personal belief is that investors should try to get away from market cap passive investing and look at alternative weightings to allocate capital around the markets.
Steinson offers another example: ‘Warren Buffet’s jibe about no one getting rich on their seventh best idea rings true; Berkshire Hathaway has two-thirds of its listed equity exposure in just six stocks.’
Therefore, instead of blindly allocating capital to active funds, investors should look to innovative asset allocation, suggests Steinson, which should include passive products.
He added: 'Passive investment strategies are here to stay but their mettle has yet to be tested in anything but straight-up markets. The bigger their market share becomes, the fewer active managers will be around to act as a volatility buffer, to sell overvalued stocks on the way up and buy undervalued stocks on the way down. This could lead to dislocations down the road.
'ETFs have played an important role in exposing the weaknesses of, and providing an alternative to, many of the closet trackers posing as active funds. They are a useful tool for thoughtful long-term asset allocators, rather than a solution in their own right.'