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The rise of indexing in wealth

Wealth managers are increasingly turning to passive propositions amid a growing focus on investment costs.

Whitechurch Securities has increased exposure to passive funds in its portfolios from zero to 10% over the past three years, Skerritts Wealth Management has upped its usage from 15% to 40% over a similar timeframe, while private banking group Julius Baer is increasingly using passives as the bedrock of its portfolios to give quick, simple and liquid access to the performance of financial markets.

Gavin Haynes, managing director of Whitechurch, said: ‘There is undoubtedly a downward pressure on cost that is leading to increased use of passive funds across the industry.

‘When building a portfolio, we will first of all look at the passive options available as they provide the cheapest and most transparent access to market returns.’

As interest in indexing and the use of passive and smart beta strategies grow, so too does the range of offerings available.

In September, Seven Investment Management (7IM) launched three low-cost, passive Ucits funds in partnership with risk-profiling firm Distribution Technology. Investing in a range of asset classes – equities, government and corporate bonds, index-linked gilts, cash and near cash, real estate and certificates of deposit, via exposure to futures and funds – they cost 29 basis points.

In January, Brewin Dolphin introduced Passive Plus model portfolios, which leverage its asset allocation committee’s tactical views, but use passive funds for most asset classes and typically cost 21 basis points – 43 less than its traditional models.

 

Pragmatic approach

Although it is easy to find a host of advisers who advocate a passive-only approach, most wealth managers are more pragmatic.

Jason Hollands, managing director of Tilney, said: ‘I’ve long held the view that index versus active debate is unnecessarily polarised, exacerbated by a handful of coal dogmatists on either side and that can drown out the more balanced middle ground.

‘The penchant for passives-only investing in parts of the industry, with an emphasis on cost mitigating, in my view is unlikely to lead to the best client outcomes. Passive investing is not a panacea.’

There is general agreement that exposure to certain markets – US equities being the one most often cited – is best attained through passive instruments, due to market efficiency. ‘There is little point in paying active fees for passive returns,’ said Brewin analyst David Hood.

In other areas, active managers have greater capacity to outperform – Rathbones highlights small caps, Whitechurch points to commercial property and strategic bonds, while Standard Life Wealth believes global high yield bonds benefit from active management.

Brooks Macdonald typically has 15-20% passive exposure for a medium-risk client and favours active solutions for the majority of non-US equities, particularly emerging markets.

‘Additionally, we favour investing thematically in our preferred areas of financials, healthcare and technology via active funds rather than indices particularly when we want a particular skew towards an emerging theme which may not yet represent a substantial weighting in the relevant index,’ said investment director Edward Park.

Other areas still are difficult or impossible to capture via a passive strategy, for example private equity and absolute return investing.

Brewin uses active funds for the absolute return part of the asset allocation in its Passive Plus models, while 7IM uses active funds for accessing frontier market equities in its AAP funds, which have actively-managed asset allocation but are composed 95% of passives.

 

Tide turning

Passives have outperformed active managers in many markets over the last few years, in part because the correlation between stocks has been substantial, making stock-picking far harder.

Park at Brooks Macdonald points to the reversal of this trend in some geographies this year. As this continues, it will create a fertile environment for active managers.

Adrian Lowcock, an investment director at Architas, the multi-manager, said: ‘The QE [quantitative easing] experiment has been a good driver for passive investors as it has effectively helped raise the value of all assets irrespective of the nature or quality of the investment.

‘With QE coming to an end and being reversed in the US, we should expect to see this support withdrawn. When markets go through their next phase we could easily see active being the strategy of choice.’

Andrew Merricks, head of investments at Skerritts, believes the next bear market will put the popularity of indexing to the test.

‘As sure as day follows night there will be a bear market at some point in the future and our natural curiosity leads us to ask the question: if, three years from now, we are one year into a bear market, what will be the reaction to the realisation that you can lose a third of your money very quickly as well as very cheaply?

‘One would hope that the curiosity, tenacity and integrity of a good active manager may steer you through the anxiety more effectively. Time will tell.’

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