Investors have been increasingly investing in passive funds since markets started going down in 2018, according to the Investment Association (IA) statistics, the trade body that represents UK investment managers.
Over the six months to the end of February 2019, UK private investors took more than £6bn out of funds overall. But tracker funds made net sales of £4.3bn. And by the end of February 2019 the share of UK investor assets in passive funds had risen to 15.9 per cent – 1.1 percentage points higher than 12 months earlier.
Passive funds have become increasingly popular over the past decade, and the recent uptick in that trend may be because investors have shifted to passive funds due to poor performance of active funds. Active fund performance relative to a benchmark can struggle towards the end of an economic and stock market cycle, as momentum carries the market on its last jump up before a downturn. During such periods share prices are driven less by fundamentals, so the best performing stocks tend to be cyclical, which active managers tend to avoid.
“When you get an inflection point you always get some winners and some losers," said Adrian Lowcock, head of personal investing at Willis Owen. "Some investors might have been in the equity funds [that did not do well] so switched to passive. Active managers struggle in peak bull markets such as we had in 2018.”
For example, over the past year, the average returns for IA North America, UK All Companies, Global Emerging Markets and Global sector funds are below those of the main benchmarks for each of those regions respectively – the S&P 500, FTSE All-Share, MSCI Emerging Markets and MSCI World indices.
However, another reason might be that investors are trying to diversify their portfolios and an increasingly popular way to do this is passive bond funds. Research company Morningstar reports that bond exchange traded funds (ETFs) made record sales in Europe over the first three months of this year, with net sales of €18.5bn (£16bn). Equity ETFs, which have generally been more popular than bond ETFs, only made net sales of €8bn over this period. And over the last three months of 2018 bond ETFs made net retail sales of €6bn while equity ETFs made net retail sales of €1.7bn.
Before that, bond ETFs only outsold equity ETFs in seven out of 27 quarters since 2012, and never by such a large margin or in such high volumes. Before the first three months of this year, their highest quarterly sales were €8.8bn in the third quarter of 2016.
A reason for the shift in preference could be a change in policy by the US central bank, the Federal Reserve, something that can affect investor demand for US government bonds and sometimes global bonds. Demand for bonds was relatively low for most of 2018 because of rising interest rates, and the tighter monetary policies implemented by the Federal Reserve, Bank of England and European Central Bank. However, the Federal Reserve has recently indicated that it will not raise interest rates this year and will hold back from winding down its policy of quantitative easing, so investors have become more bullish on bonds. This has been followed by a sharp rise in the number of bond ETF launches.
However, over the 12 months to the end of February 2019 active fixed-income funds experienced outflows of £2.97bn, according to the IA. But analysts have warned investors against piling into any kind of passive fund at this point in the cycle because markets could be set to go down in the not too distant future.
“Going into passives is counter-intuitive at this point in the cycle," said Mr Lowcock. "Rather, you should buy [a fund run by an] active manager that can protect on the downside."
And Rory McPherson, chief investment strategist at Psigma Investment Management, thinks the only kind of bonds you should invest in via passive funds are government bonds - the safest and simplest type of this asset.
“We prefer active managers for bonds because half of this market is made up of non-economic investors, such as central banks and insurers, who are not concerned about price and buy bonds because they have to," he explained. "So active managers can buy and sell these bonds from these agents at good prices. Also, a fifth of the bond market matures every year, which passive funds hold. But active managers can pre-empt this and make additional returns.”
