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Aurum CEO: passives are perverting risk analysis

Aurum CEO: passives are perverting risk analysis

Aurum CEO, Kevin Gundle, takes a closer look at the problems posed by passive funds when it comes to gauging overall risk for portfolios. In the first of a four-part series, Gundle considers hidden concerns.

There has been a lot of debate in the press recently around the investor trend towards passive investments. Given this, and the enduring popularity of the “balanced portfolio”, I wonder if some investors are in for a short Sharpe shock.

It is human nature and a well-known fact that what gets measured tends to be what is easily measured. In the world of fund management, the two items that are most easily and frequently measured are fees and performance. Investors often overlook measuring risk entirely.

When it comes to active fund management, this approach to measurement has resulted in net capital outflows from active funds into passive investments. According to Morningstar, 2016 was one of the worst years for active management fund flows.

US actively managed funds saw outflows of $340 billion for the year. Passive funds, dominated by Vanguard Group, the poster child for passives saw $505 billion of inflows in 2016. The reasons for the shift in assets away from active and into passive are part structural, part cyclical and in no small part driven by performance versus fee evaluation.  

The structural shift from active to passive can be explained, in part, by growth in assets and changing trends in global pension plan systems. In the US use of 401k plans continues to grow and many employers are opting to provide qualified default funds to relieve them of financial liability.

According to ASFA, the Association of Superannuation Funds of Australia, Australian superannuation fund assets continue to grow, reaching $2.3 trillion in March this year up 11.2% over 12 months. In Australia just under a third of superannuation fund assets are held in self-managed superannuation funds. 

In the UK, DC schemes are seeing rapid growth along with ISAs, SIPPs and LISAs – which could become the vehicle of choice for a new generation of savers.

From a cyclical standpoint, investors have experienced a sustained bull market in equities during which the average active manager has underperformed the main indices.

Investors have felt that the performance offered by actively managed funds is not compelling when compared to passive indices, and that the fees charged are not justified by the results achieved. Active management is having a torrid time demonstrating its relevance.

All this leads to investors making the simple choice of opting for a cheap index fund that is generating good returns - but who is considering how to measure the risk that may be lurking in investors’ portfolios, and what the future may hold for index funds when markets turn?

Do the majority of investors have the tools, data or expertise to measure risk? Do they understand risk indicators such as the Sharpe ratio? Quite often they don’t, which brings us back to the point that what tends to get measured is what is easiest to measure.

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