In the past three years, tracker funds have recorded remarkably similar net inflows of £18.3bn, £18.4bn and £18.1bn, respectively, according to the Investment Association (IA).
However, while there have been positive inflows of £7.4bn into passives over the year to August 2022, demand has slowed. In June, the IA actually recorded outflows of £41m, so are asset allocators opting more for actives in market conditions where trackers are proving volatile?
“Market volatility has a tendency to shake the hot money out of markets and in recent years this kind of short-term approach has been using passives as a quick, cheap and easy way of riding the wave of rising markets,” says Ryan Hughes (pictured), head of investment partnerships at AJ Bell Investments.
“Clearly, the past year has proven to be a very different environment, with many of the biggest companies in the major indices struggling given their technology and growth focus,” he adds.
“As a result, the slowdown in demand from passives perhaps shouldn’t come as a surprise.”
Style matters
Despite this, given that historically so many active managers fail to beat their benchmarks and, taking a long-term view though the volatility, Hughes says a large number of advisers are still allocating to passive portfolios.
“While volatility is sometimes seen as an advantage to active managers, this is too simplistic given that style matters so much more,” he says.
“Due to the huge swing in style bias from growth to value over the past 12 months, there has been a complete reversal in the type of active manager performing well – and it’s for this very reason we always run style-diversified portfolios.
“We haven’t made any shift in our split between active and passive this year but continue to assess each investment decision on its own merits as to the most appropriate method of implementation,” Hughes adds.
“Our fundamental approach to the active versus passive debate is that they both offer potentially distinct benefits in different situations,” says Chris Metcalfe, chief investment officer at Iboss. “We always start with the balance of probability test, which is effectively ‘do we think a given active fund can outperform a passive alternative net of fees provided the market conditions?’”
As a result, Metcalfe says the use of passive funds ebbs and flows over time, given market conditions. At the same time, he adds there are also situations where he wants to keep a greater degree of control.
“For example, in the past few weeks, we have increased the duration of our bond allocation via the Vanguard US Government Bond Index (hedged),” he says.
“This gives us a high degree of certainty about the asset make-up, duration and currency. We blend several funds together in each sector, and if we used purely active managers, we would have limited visibility of the overall make-up of portfolios.”
Within Iboss’ equity allocation, Metcalfe notes the current active/passive split is 75/25 in favour of active. “It’s imperative to understand what a passive vehicle is tracking when it will do well, and when it will struggle,” he says. “We use the L&G US Index Trust, which closely follows the S&P 500 and is very growth-orientated, so we know what to expect from it.
“We currently pair this with the active M&G North America Value Fund,” adds Metcalfe. “These have little commonality, but it’s the M&G fund that can take advantage of market volatility. The manager had benefited from buying value assets before the Federal Reserve realised inflation wasn’t transitory and, in fact, is the biggest issue facing the US economy.”
Rotation to value
While passive funds did suffer outflows in June, William James, investment manager at Square Mile, notes outflows for the entire sector hit £4.5bn. Given passive represents 20% of the market, he says this highlights a disproportionate amount of outflows occurred in active funds.
“This is not surprising given active funds have been having a tough time since the market rotation in late 2021, where value styles have been more favoured given their larger allocations towards those sectors that have done well, such as energy,” he says.
James adds: “A further reason for the active underperformance has been their tendency to have larger allocations towards small- and mid-sized companies, which have fared poorly compared with larger companies in 2022. An increased domestic focus is a key reason, as opposed to larger companies that have more dollar-denominated revenues.”
While it remains to be seen whether this trend will continue, James says history suggests the underperformance of active versus passive will revert, and when it does it will do so aggressively.
James adds: “Where appropriate, we back active managers to outperform, and believe that a mix of both active and passive funds is most suitable where costs allow.”
Adam Lewis is content editor at Bonhill
This article first appeared in the November edition of Portfolio Adviser Magazine
