The drive towards passive investing often gets conflated, particularly with the regulator’s current focus on value for money.
While lower costs must be welcomed across the value chain, that doesn’t necessarily mean that passive represents the right solution for clients.
Firstly, it is important to highlight the Financial Conduct Authority’s (FCA) approach. The FCA continues to monitor the advisory, discretionary and asset management sectors to ensure that firms are delivering value for money for clients, and that competition is functioning effectively.
The regulator hopes MiFID II will play a role in this by improving transparency and laying bare all costs and charges for the underlying investor.
Likewise, the Product Intervention and Product Governance Sourcebook (PROD), which was introduced with MiFID II in January 2018, requires advisers to create segments and sub-segments across their client-bank, grouped based on characteristics and needs. These then need to be matched to a platform, investment solution and advice service. The adviser has a responsibility to evaluate each component in the value chain to ensure the cost and service are appropriate for the intended client segment.
Against this backdrop, it is easy to see why some advisers and discretionary fund managers (DFMs) have leaned towards passive funds as a means of driving down costs in portfolios. What’s more, passives have largely delivered in one of the longest bull markets in history.
Looking ahead, passives still warrant a place in portfolios as a means of providing tactical low-cost exposure to efficient markets. However, the tide appears to be turning as we gradually approach the end of the bull market.
In a recent article for Professional Adviser, Mickey Morrissey, a partner and head of distribution at Smith & Williamson Investment Management, explained why:
“These returns look unlikely to be as easily won in future. Amid political uncertainty and technical disruption, investors will need a more nuanced approach.
“While there is undoubtedly value in holding passive investments, whose structure can offer exposure to specific sectors or geographies at very low cost, we strongly believe these should be viewed as most beneficial when used tactically, as part of the asset allocation of a sensible and well diversified actively-managed portfolio.”
Advisers and DFMs alike must make sure that they are not driving down total expense ratios (TERs) or ongoing charges figures (OCFs) at the expense of return.
Passives typically invest according to market capitalisation, which means that investors run the risk of allocating to areas that have already performed well and they may be buying in at the top.
Mickey sums up this scenario well:
“Over the long term, valuation is the core driver of the market, not sentiment.”
Likewise, passive investing is underpinned by the assumption that markets efficiently incorporate all relevant information and this is reflected in prices; this represents a statement that many investors would take issue with, based on the performance of markets through history.
As we approach more challenging market conditions, marked by pronounced bouts of volatility, investors may find that actively-managed funds with strong management teams, processes and track records deliver attractive returns. They can do this by targeting mispriced opportunities and avoiding problematic areas of the market. The upshot is that they could have the potential to deliver value for money, even once higher headline charges are deducted.
Ultimately, the regulator wants advisers and DFMs to consider headline charges, but also to demonstrate that they have the client’s best interests at heart. This should underpin all investment decisions – regardless of whether they are active or passive.
This post was created for the DISCUS website in reference to comments made by Mickey Morrissey of Smith & Williamson in this article for Professional Adviser Magazine. You can find out more about their investment services here ›