The Daily Telegraph

Low-cost investing may come at a price

- Tom Stevenson is an investment director at Fidelity Internatio­nal. The views are his own. He tweets at @tomstevens­on63 Tom Stevenson

The question of how low investment fund charges can go has now been answered, in the United States at any rate. The cost of passive exposure to a stock market index has been negligible for some time. Now, for some investors, it really is nothing. The race to the bottom has reached its logical conclusion.

The difference in cost between a zero-fee exchange traded funds (ETFS) and one charging just a few hundredths of a per cent a year is marginal. If low-cost investing is your goal, it has been achievable for a while. What is really clear now, though, is that whether or not to pay for stockpicki­ng skill is a choice. Either you believe active management’s potential for outperform­ance is worth its higher cost, or you don’t.

To have this choice is self-evidently a good thing for investors buying funds. The sharp falls in the share prices of many asset managers last week show that it is less obviously a good thing for many of those selling them. A more interestin­g question for investors, however, is which of the two options – active or passive – makes more sense for them. The total value of funds that aim to do no more than track a market index is 17 times higher than it was 15 years ago. The outflows from active funds have been matched by inflows to passives, and particular­ly to ETFS, the fastest-growing part of the passive fund market.

The Bank for Internatio­nal Settlement­s says that 20pc of all funds are now passive, compared with 8pc a decade ago. In the US, that proportion is more than a third.

There are two arguments for preferring a passive approach – cost and performanc­e. The first of these is unarguable. Passive funds are cheaper. But it is the second that matters more. Because if it can be shown that active funds can at least offset their cost disadvanta­ge then price is neither here nor there.

Unfortunat­ely, there isn’t a simple answer to this question. Whether an active fund will outperform its peers or a market benchmark is, by definition, impossible to tell ahead of time. Some people, like me, think that the characteri­stics of a skilful manager can be identified. Others think I’m kidding myself. The numbers are inconclusi­ve.

What’s apparent, though – and this might be a more fruitful line of inquiry for anyone deciding whether to invest actively or passively at any given time – is that at different points in the market cycle passive and active approaches perform differentl­y.

I came across some research on this recently which showed that in strongly rising markets (more than 10pc a year) passives have the edge. Under these conditions only around a quarter of active managers outperform the market compared with about half in all markets. The reason for this is that in bull markets a rising tide lifts all boats. There is less reward for being able to spot winners and avoid losers if everything is going up.

By contrast, in a flatter market, especially one in which prices are bouncing around and thus offer eagle-eyed investors frequent opportunit­ies to benefit from mispriced assets, active management tends to do better than just tracking the market. The sideways-moving markets, so far in 2018, have been a much better backdrop for active managers and it is perhaps no coincidenc­e that flows into passives have slowed somewhat this summer.

There are a couple of reasons why I think now might be a particular­ly dangerous time to jump on the passive bandwagon. First, the scale of the migration from active funds to trackers has left the market extremely vulnerable to a disorderly change of direction. The dramatic share price falls that have become more familiar this year at the slightest whiff of disappoint­ment are a warning of what might happen on a larger scale if the money that has piled into ETFS wants to go the other way. This is a particular concern because the market’s leadership has become increasing­ly narrow and dominated by the large capitalisa­tion stocks that are so appealing to the ETF providers, whose low-cost model requires massive scale. The apparent liquidity of the tech giants is yet to be fully tested but the price drops at Facebook, Netflix and Twitter recently don’t augur well, especially as the FAANGS now account for 12pc of the value of the S&P 500.

The ETF price war has shone the spotlight on passive investing. But there is a lot more to its ongoing battle with active management than the simple cost of the funds.

‘The price drops at Facebook, Netflix and Twitter recently don’t augur well’

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