In a low-return environment, actively managed funds’ increasing fees are coming under increased scrutiny and many investors now see passives as a viable alternative.
These strategies not only cover key markets but are now becoming more specialised and sophisticated. A gender equality Ucits ETF from UBS and a European Equity market neutral ETF from Amundi are just some of the niche approaches on offer.
What does this mean for our Selector 100, are they poised to use these products to their advantage in the year ahead?
Eric Grandjean, head of investment funds at Indosuez Wealth Management, says 2018 will continue to challenge selectors as the pressure on fees increases.
‘Central bank action has been a major factor in the rising popularity of passive investments. Against a backdrop of low-interest rates, stocks and bonds have risen indiscriminately.
‘On equities, the correlation between stocks is now approaching its lowest level for more than 10 years. As the tide of cheap money recedes as a result of a less accommodating stance from central banks, those who have been swimming naked could be caught out.
‘2018 promises to be a more challenging market and we expect active managers’ selection skills to come to the fore,’ he says.
At the same time, Grandjean says there will be continued pressure on fees. ‘There is likely to be a progressive shift from fixed to variable fee structures in fund management,’ he says.
Meanwhile, Lionel de Broux, senior portfolio manager and head of funds research (pictured below) at Banque Internationale à Luxembourg, says passive strategies are likely to benefit from regulatory changes.
‘The inducement ban for independent advisory and discretionary management should support a core/satellite approach, where investors can combine passive investment solutions with more aggressive alpha providers.
‘Therefore, we should not be surprised to see fund ranges focusing on their best-performing or more innovative strategies at the expense of core funds with low alpha capability.’
De Broux says an increasing number of players are developing their ETF platforms and differentiating themselves by offering lower-cost or smart beta strategies.
‘These products – based on a model or systematic investment rules – are exposing investors to significant biases.
‘Our responsibility is to make sure such offerings meet investors’ expectations.’
This systematic, rules-based approach makes many investors uncomfortable investing in ETFs. Jonathan Cohen (pictured below), a portfolio manager and fund selector at Reyl & Cie says selectors should keep a close eye on risk and returns.
‘The issue of cost is always coming back to the table. Passive solutions offer a strong investment vehicle with a cost-efficient approach, but we are more focused on opportunities in the entire market.
‘What we don’t like with passive solutions is that at a certain point it’s a consensus-driven approach.
‘It’s like a trend situation, you have a lot of flows that pull other investors in, it’s a snowball effect,’ he says.
‘A more challenging market, with increased volatility, especially in equities, can have a bigger drawdown on this liquidity and flows effect, and that is not what we want for our clients.
Cohen says when you look a little beyond the benchmark there are more opportunities and less crowded trades. ‘That is partly how we tackle those issues, we are looking for more active solutions than passive ones,’ he says.
Despite this active edge cited by Cohen and many others, Chantel Brennan, director of research at Davy, says globally, passives are putting pressure on the margins of active asset managers.
‘We have to look at what that means for the long term. I say that because passives are essentially predicated on buying the same stocks again and again, be that the FANGs [Facebook, Amazon, Netflix, Google] or BATs [Baidu, Alibaba, Tencent] in Asia, essentially the companies that become big enough to have a major market impact.
‘People will pile in through passive products but what happens when they want to withdraw?’
Many investors have voiced concerns about being able to exit, and Brennan says these fears come from the systematic nature of the process.
‘There isn’t a human being overseeing that, it is a machine, so it will indiscriminately sell. This could easily pose a problem in the fixed income world as well.’
Active on passives
However, many selectors are broadening their use of passive strategies to meet more of their clients’ needs.
Jörg Schmidt, a senior portfolio manager and head of manager selection at Union Investment, says his team use passive strategies, but not via ETFs.
‘Instead, we are using futures to create an overlay on active managers if we want to increase or decrease our equity allocation without selling or adding to certain funds.
‘However, futures are not a strategic building block for our portfolios because we believe in active management and those fund managers we chose in the past delivered great returns. The case for futures is simply that they are not cash consuming and can be used quite effectively as an overlay to our fund investments,’ he says.
Many other investors, such as James Millward, investment director of fund solutions at Aberdeen Standard, see passives as a complement to active funds, rather than a threat.
‘If we think active management is the best way to access a particular asset class we will seek out the most skilful managers.
But if there are asset classes that look more efficient or where the dispersion of returns isn ’t significant and we need to reduce cost, then passive or smart beta options might be really useful,’ he says.
‘For example in our passive fund range, we don’t use index managers in high yield, where we think active managers are more efficient. In our multi-manager ranges, we will selectively use passives where we think it is harder to outperform. We have a minor passive component in our US equity selection, for instance.’
Millward says the pressure on costs is obviously beneficial for clients.
‘Due to our scale, we have always negotiated access both to passive and active managers very competitively. I think this is just a broader opportunity set that we can consider and a bigger toolkit, which is going to benefit clients in the long run.’
Selectors in the Spanish market, such as Daniel Aymerich (pictured below), head of fund selection and distribution at Andbank, also champion a blend of passive and active strategies.
‘Competition always forces us to improve, and active and passive have complementary properties that should cohabit naturally in a portfolio. We use both approaches to meet distinct needs.
‘Easier access to passive strategies weighs on the level of performance and consistency we demand from active managers.
‘In the end, the rise of passives is an advantage, because our purpose is to better serve the investors, and no matter what, good active managers will always exist,’ he says.
Over the past year, Citywire Selector has profiled many fund selectors for its regular Passives Pulse feature and the key indicator, coming from many markets across Europe, is that investors are using ETFs in markets where it is hard to find good active managers. This is a view that Deutsche Bank’s head of fund selection, Ian Crispo, subscribes to.
‘We are mainly using passives in the main plain vanilla core markets when we require more trade-oriented approaches and need to go in and out of certain sectors many times. For example, you can allocate to passive strategies on a short-term basis in the US large-cap sector.
‘On a long-term basis, we have fund managers that are offering strategies that should offer more protection on the downside when these markets correct. It doesn’t mean these have to be liquid alternative strategies.’
Crispo says the team looks mainly for equity strategies that are more unconstrained and have the ability to be more defensive at times or are managed in a more conservative fashion.
‘But we certainly use more passive strategies for short-term oriented trades and active managers for long-term bets,’ he says.
Tipping the balance
DNB’s head of manager selection, Fredrik Wilander, is another fan of ETFs but he wonders whether the increasing use of passives will influence markets themselves.
‘One thing active managers need to watch out for is how the strong inflow of passive capital affects the equity markets and the allocation of capital. I have been of the view for a long time that if you invest passively, meaning market-cap weighted, then you are not really distorting the markets.’
However, Wilander says his team is now seeing underlying signals in the capital markets that may be associated with a strong inflow of passive capital.
‘It is too early to tell for sure, but the performance of growth vs. value, large cap vs. small cap, the contribution to equity market returns from a few mega-cap companies, as well as momentum returns, could be related to passive flows. These are discussions we are having,’ he says.
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