One of the most striking changes in investor behaviour of the past 10 years has been the increased use of index-tracking products. Passive mutual funds, exchange traded funds (ETFs), and more recently smart beta products have increased in volume in the teeth of both recessions and equity market booms.
In 2014 alone, there was an €80bn net inflow into passives, pretty much evenly split between open-ended funds and ETFs – see chart 1 for a full breakdown. If you look at graph 2 you can see how the biggest three categories of ETFs did: equity, bond and commodity. Aside from a couple of glitches (fixed income in 2011 and commodities in 2013 and 2014) money has poured into ETFs for the past five years.
There is a similar story with open-ended passives. Looking ahead, it does not look like this trend will change soon. Graph 3 shows that across Europe more than a quarter of all fund selectors and asset allocators are intending to use more passives in their portfolios over the next year – only a small number are planning to reduce their weighting. That aggregated number does hide a substantial variability – only half of the Portuguese investors use index trackers, as opposed to 90% in Luxembourg – but broadly it is clear that these products remain popular with high level fund selectors.
What is driving the trend? When asked, individual fund selectors cited a variety of reasons they use index-trackers, but in the main it was to make short-term bets. Fund selectors are also invested fairly widely in terms of asset classes and regions depending on their respective portfolio risk profiles and assessment of regional and sector economies and performance.
Focusing on France, we can see from chart 3 that fund selectors there are moderate fans, with 16% seeking to increase their allocation and 63% to maintain it. While having always used trackers for small investments of up to 10% of a portfolio, Tristan Delaunay, chief executive officer and head of fund selection at Athymis Gestion in France, currently holds 0% to 2%. He adds that he has a new “small position in one smart beta fund” representing 2% to 3% of portfolio.
In Finland, index trackers are very popular, with more than 40% of fund selectors looking at increasing their allocation. Consistent investing in these instruments has been the strategy for Evli Bank in Finland. “We have kept the levels the same for almost two years in passive index tracking ETF- products,” says Tanja Wennonen-Kärnä, senior portfolio manager for Evli Bank.
She says the passive products the bank uses vary a lot depending on the type of client – private bank, institution, foundation, company. And while Evli does not currently have any smart beta products in its portfolios, Wennonen-Kärnä says it is something Evli is considering.
In Norway, the average fund selector would appear to be selling off his passive holdings, but others are bucking this trend. Arild Orgland, managing partner at Industrifinans in Norway, says: “Overall, we have increased the use of passives quite substantially,” he says, “but that’s mainly because our institutional client business has increased a lot. Our private clients are more absolute return oriented and are still primarily using active funds.”
It tends to be the case that passive funds are short term holdings, held often for tactical reasons. “ETFs are quoted and so are more liquid, and smart beta funds are easier to predict and able to mimic indexes that are difficult to beat,” says Delaunay. Wennonen-Kärnä agrees: “We mostly use passive products tactically, short term, but also when active managers do not have their best period (as US managers did in 2014).”
Orgland says that institutional clients use passive funds both as core holdings and for tactical purposes and when rebalancing portfolios. “The advantage of passive funds is that you avoid having to explain negative deviations in returns,” he says. “They are also cost efficient. We notice, however, that the fee differences between passive and active funds are decreasing.”
Fund selectors are broadly agreed that, whether investing for individuals or institutions, it is risk profile and the costs of portfolio management that dictate selection rather than any preference on the part of clients. Where there is client input, Orgland says: “Institutional clients tend to be more oriented towards relative risks to benchmarks, measuring relative volatility, tracking errors and information ratios – while our private clients are more focused on absolute returns and sharp ratios. It is quite obvious in this context that index funds have the greatest appeal to institutional clients.”
From a client perspective, the advantage of passive funds is of course that you avoid having to explain negative deviations in returns. Index-trackers are a cheap, but also a bit of a lazy solution perhaps, as it guarantees you performance in line with the market, but nothing more than that.
So composing a portfolio which consists of a cheap, passive core combined with highly active funds might sound like a good compromise. Click here to watch a video interview we recently held with Rishma Moennasing of Rabobank in the Netherlands, in which she explains their core-sattelite approach for fund selection.