The problem with passives
The latest investment sales figures from the Investment Management Association (IMA) show the highest funds under management on record for tracker funds.
In the first quarter of 2010, £510.9 billion of investor cash was held in passive funds, compared to £348.9 billion for the first quarter of 2009. This represents an increase of £162.0 billion or 46% in one year.
The market rally since March 2009 would have helped to boost funds under management in this fund type. Certainly other types of funds have also witnessed big increases during the same period of time.
One the main reasons cited for using passive or tracker funds is their low cost. The UK still has some way to go before the average cost of these funds is as low as it is overseas, particularly in the US where the market for these funds is better established. However, the costs quoted are still relatively low.
Some research from Lipper in 2008 found average total expense ratios (TERs) of 1.66% for actively managed funds. Morningstar reported last year that the average domestic equity tracker in the UK has a TER of 0.89%.
At first glance, this cost saving of 0.77% per annum looks very attractive, particularly in a low return environment and when compounded over the longer term. What is misses however is two very important costs.
The quoted costs of actively managed funds include the cost of an investment platform (typically 0.25%) and the cost of adviser remuneration (typically 0.5%). You certainly need the former and you probably need the latter.
Adding these two costs to the average passive fund TER of 0.89% results in a 1.64% TER – only two basis points behind the average cost for actively managed funds. All of a sudden, the cost saving is less dramatic.
Comparing like with like should be a requirement of every financial adviser offering unbiased advice to investors. If the passive argument is supported on the basis of cost alone, it starts to look much weaker.
In reality, averages hide many things. It is possible to find cheaper passive investment options than the averages quoted here and more expensive actively managed funds. Other factors are equally if not more important than price, and it is the value you receive from a particular investment approach that makes the real difference.
When we build portfolios for clients, we see a role for both active and passive funds. Where a market is inefficient and we can identify a competitively priced active fund with a high ‘active share’, so investors are not paying extra to essentially track an index, it can make real sense to go down this route.
Passives will play a growing role in investing as the UK market for these funds continues to mature and Exchange Traded Funds (ETFs) become more widely available.
When making important investment decisions, do not allow an evangelical view of passive investments to distort the investment choice, particularly if the advocate is comparing net management costs with those including other factors to win the cost argument.
Sorry but your numbers are flawed – a passive portfolio can be purchased on a platform for no more than 0.5% (eg Vanguard UK Equity tracker at 0.15% and platform charge of 0.35%). Adding an advice fee 0f 0.5% still ensures a guaranteed cost saving of 0.5% every year in comparison with an active AMC.
However the AMC is only part of the story and you will find that TERS wil usually push the figure up to around 2.4% and then PTR costs of easily another 1% for most funds – so total costs of active withe advice are over 3% v Passive with advice of 1% hmmm .
Do the math as they say…
Thank you for your comments, Andrew. I was careful to point out in this blog that the TER numbers used were averages and that it is always possible to find cheaper passive investment options than the averages.
The main reason for highlighting this issue is that tracker fund AMCs and/or TERs are often quoted net of platform and adviser fees, whilst active fund charges are usually quoted inclusive of both. In the interests of transparency and fairness, a like for like comparison should always be made, particularly when cost is a big argument (although not the only argument) behind the passive position.
As an investment adviser, we do not have an axe to grind when it comes to passive or active management. Both style of investment approach can play a role within a client portfolio.