The rise of passive investing. And the demise of investment managers?

Investment in passive funds has grown from £17 billion in 2004 to £80.6 billion today, boosted by regulation and the global recession.

Investment in passive funds has grown from £17 billion in 2004 to £80.6 billion today, boosted by regulation and the global recession. Compared to the 1% fee charged by active investment managers, passive funds charges are often around 0.2% and can be as low as 0.07%. As passive Exchange Traded Funds (ETFs) and unit trusts grow, outflows from active funds and inflows into passive funds are likely to follow. How will traditional investment managers survive?

Active vs. passive
Charities, corporates, pension funds and individuals have trusted their ‘active’ investment managers (those that select stocks and bonds on behalf of clients) for the past fifty years. All over the world, investors take comfort from their investment managers’ ability to pick under-valued stocks (and bonds) and reduce portfolio risk – without compromising returns. However, whether investment managers actually achieve their objectives has fallen under the spotlight and the results are often disappointing.

Nowadays technology provides investment managers with near-instantaneous access to the same market information, and it is nearly impossible for active managers to generate returns superior to the competition. The returns are generally poorer after fees. A typical fee of 1.2% of invested assets is akin to 17% of returns if equity returns are around the 7% per annum that is consensus (see first chart below). Over 10 years, the impact of the 1% fee differential between active (1.2%) and passive (0.2%) managers is £867 on an initial investment of £5,000 (that’s over 17%), as shown in the difference between the two bars in the second chart.

Passive Investing Graphics

Selecting investments that are so under-priced that they will outperform and outweigh this £867 ‘fee-drag’ is virtually impossible, especially in developed markets. 85% of actively managed funds failed to exceed their benchmark (or were closed or merged) over the 15 years to December 2013 (source: Vanguard, 2014).

Given most managers underperform their benchmarks, it is unsurprising that a new investment category – passive index investing – has arisen. Index or ‘passive’ investing involves investing in a fund that mirrors or replicates a market index (e.g. FTSE 100), without the cost and research teams associated with actively trying to beat it. Passive investments are increasingly accessible to investors, both retail clients and professionals.

What’s next for investment managers? The value-driven approach
Investment managers may ignore the active vs. passive performance differential and continue collecting fees until clients move away. Or they may shift their business model (and importantly, their marketing) to a more open value-driven approach. Clients trust their investment managers not only to select winning stocks, but to look after the important elements of portfolio risk, investment objectives and their long term strategy. Proactive investment managers will move the debate away from their preferred stocks towards broader issues of economics, asset allocation, risk, expected return and – crucially – their clients.

The time previously spent on stock selection can be redirected into discussions about client aspirations, risk tolerance and ‘suitability’ – a topic that is under the spotlight of regulators in the UK. Clients’ expectations and needs such as life events, portfolio withdrawals and reliance on portfolio income should become investment managers’ focal points.

Clients may be surprised to learn that their manager can no longer choose investments which outperform the market, but they trust their advisors to provide honest advice and will still need them to design, monitor and adjust a passive investment strategy. Investment managers will have to work harder to justify their fees but those that are proactive and client-centric will be rewarded with loyalty. The alternative – the status quo – will more likely alienate clients over the long term and erode fee income as clients are wooed away to cheaper and better-performing providers.

Interestingly, the founder of Nutmeg said that out of ‘thousands’ of clients, only five had ever taken him up on the offer of a face-to-face meeting (source: Investment Week, 2014). It is likely that clients who value personal relationships have chosen to stick with their existing managers, but will they continue to do so if (arguably when) the performance differential becomes better known? What if the values of client service and client understanding were applied to a passive investment strategy to deliver the best of both worlds?

To sum up, the investment management environment continues to evolve and challenge providers. With technology making outperformance virtually impossible to achieve, plus a spotlight on whether managers do actually outperform and the rise of passive investing at low cost, it is time for investment managers to reconsider their investment and client service models – before clients force them to do so.