Passive funds riskier than investors realise, say financial advisers

Almost nine in 10 financial advisers believe investors do not understand the risks associated with UK-based passive funds, according to new research from Ignis Asset Management.

The research, conducted in early April and based on more than 220 responses, reveals that 87% of advisers believe UK investors fail to fully appreciate the risks posed by funds that passively track the FTSE 100, due to the handful of individual stocks and sectors that dominate the index.

More than a half of advisers (57.5%) said passive funds were ‘somewhat riskier' than investors realised, while a further 29.9% stated they were ‘significantly riskier' than typically acknowledged.

Moreover, the research reveals that, contrary to widespread expectations, the RDR is unlikely to prompt advisers to significantly increase their clients' exposure to passive funds. More than two-thirds of advisers (68.3%) said they expected their current usage to remain the same, with 9.5% planning to actively reduce their usage. Just 22.2% of advisers said they would increase their clients' exposure to passive funds - and only 6.8% by a ‘significant' amount.

Although the RDR is set to have a negligible impact on passive funds, the vast majority of advisers do believe forthcoming regulation will exert pressure on ‘closet trackers' - actively managed funds that display little deviation from the market. Almost nine in 10 advisers (87.2%) said closet trackers would come under increasing scrutiny in the post-RDR world, while 77.6% said benchmark-constrained active retail funds are becoming increasingly less relevant in today's market. A further 84.9% agreed with the statement that, ‘given the freedom to perform, quality active managers will almost always outperform passive funds in the long term'.

Advisers' views on the ‘passive versus active' debate appear set to have a significant impact on portfolio construction, furthermore. More than four in 10 financial advisers (42.3%) said portfolios would increasingly adopt ‘reverse' core-satellite approaches, with active funds at the core and passive funds used tactically. Just 28.4% believed the conventional core-satellite approach - with active funds used to complement a tracker-based core - would increase in prevalence.

Finally, in a warning to the industry, almost three-quarters of advisers (72.7%) stated that fund groups prepared to tolerate long-term middling performance would struggle to retain third party assets in future.

Commenting on the findings, Rob Page, Ignis Asset Management, said: "Conventional thinking has been that passive funds would explode in popularity following the RDR but our research clearly questions that premise. Indeed, advisers are more concerned that investors in FTSE 100-based passive funds do not fully appreciate the risks they are taking  by tracking an index so heavily skewed towards a handful of sectors and mega stocks.

"For fund groups committed to quality active management the news is more encouraging, as most advisers believe quality high alpha managers are more likely to generate superior performance in the long run. But it is clear that the time is up for fund groups that charge active fees for benchmark hugging returns."