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Risks and Side Effects of Passive Investing

The recent surge in passive funds & ETFs has increased choice but also created more uncertainty around the best course of action for investors. Passive products are often portrayed as ‘simple’ and ‘low risk’ but they can be just as complex and present just as many risks as active products. So, what does an investor need to know about passive investing?

For an actively managed fund, a team of specialists makes on-going adjustment of a range of investments based on research and analysis. In contrast, a passive fund is set to automatically follow the fortunes of a securities index.

Passive investing has gathered increasing interest amongst investors, especially with the growing use of Exchange Traded Funds (ETFs) which are funds that track an index or basket of assets. The main perceived benefits are their low cost, their tax efficiency, and their ability to offer diversification.

While index-tracking funds can help make investing more accessible to novice investors, there are several key risks and side effects which all investors need to consider before committing their money to a passive investment strategy.

Losses and gains cannot necessarily be controlled

In a typical passive fund, assets are equally at risk of making losses in the relevant market, as they are likely to benefit from making gains. Once the money is invested, nothing is being done inside the fund to try to mitigate potential losses should the market go down.

There is a growing concern that the recent surge in popularity of passive investments has occurred at a time when the investment climate has only ever been favourable. Some investors have never experienced a less positive environment, and when that comes – which it inevitably will do due to the cyclical nature of markets – some investors might be caught out by their losses. Holders of passive funds need to be aware that they have full responsibility for managing the value of their investments during financial market upturns, as well as during downturns. Unless they seek financial advice at the right time, they might not be in a position to manage the risk of loss of their passive investments in the way they prefer.

Conversely, active managers have the ability to adjust the investment portfolios that they manage in anticipation of, or in reaction to, adverse market conditions. They can monitor the risk of loss actively, which if done successfully, can help with mitigating a decline in the value of an investment. They won’t always be successful, but at least the investor can have peace of mind knowing that the manager will at least be able to try to protect their assets during a negative market event, although this cannot be guaranteed.

The market impact of asset trading by passive funds and ETFs

The investment activity of passive funds and ETFs often triggers unintentional side effects on financial markets following changes in the composition of indexes. Since passive funds and ETFs track these indexes, a lot of trading happens after index changes become effective which in turn can move the market prices of assets to above or below fair value.

Given the sheer number of market participants now involved in this increasingly popular market, passive funds may also suffer from ‘crowded trade’ risks. Put simply, if the market cools and a large number of investors suddenly decide to exit their investments, it could trigger a wave of similar behaviour which would quickly reduce the value of assets held by the remaining investors.

The same is true for episodes of sudden enthusiasm and related price rises. In acting within a short period of time, passive funds and ETFs can distort some market prices by way of indiscriminate trading.

As more and more people put money into passive funds, the prices of infrequently traded, so called ‘illiquid’, investments could rise dangerously above what can be considered to be a reasonable price for a company or security. This could lead to too much money being used to buy those assets and a greater vulnerability to those assets suffering a fall in price as their market value adjusts towards the intrinsic value.

So, some indices are constructed with more illiquid constituents than others. Less trading activity in a market can create pricing inefficiencies in an investment. For an investor trying to access smaller asset classes, such as high yield corporate bonds, index characteristics are important to understand in breadth and depth.

The risk of choosing to invest in a passive fund which replicates the wrong index

Not all indices are born equal which means there are some indices which work well for investing, and others which do not.

For example, you might use this simplistic checklist below when making your assessment. If there is transparency, clear objectivity and easy access, then you are more likely to be looking at a “good” index:

Index checklist for investors

‘Good’ index

‘Bad’ index

Sector weighting

Evenly spread

Concentrated

Calculation method

Market capitalisation (size)

Price weighted

Number of constituents

Large

Small

Liquidity of constituents

High

Low

By ‘good’, we mean indices which best represent an asset class for the purposes of risk-controlled long-term investment, they are not necessarily more likely to be profitable. If an index is not doing that, we would consider it to be “bad”.

Passive funds aren’t perfect replicas of financial markets

The degree of how closely a fund reflects the composition of the security index it tracks is called ‘tracking error’.

In the case of indexes which are composed from a large number of securities, passive fund managers would incur prohibitively high costs to purchase the thousands of securities necessary to exactly replicate the index.

In these cases, fund providers will be forced to apply techniques to select some smaller representative set of securities instead. They will still want to aim for the passive fund to achieve the performance characteristics of its index, but some techniques work better than others.

Keep in mind that this approach to fund management inevitably introduces some tracking error which can affect the risk and reward profile of the passive fund, in some cases materially. So when investing in index-tracking funds or ETFs which track a large number of assets, it pays to read the fine print of the fund documents as it always does.

Expensive passive funds also tend to track the index less well due to the higher cost of tracking, which means that tracking error needs to be considered carefully.

There can be justification in avoiding tracking a index in certain market conditions. For investors looking for smooth investment returns, the tracking of a highly volatile equity market would not always make sense.

Cost transparency needed for both passive as well as active funds

Despite passive funds generally being more tax efficient, more transparent and cheaper when compared to other investment strategies, investors still need to consider the full cost implications of using them. These will entail fees in the form of a combination of asset management charges, commissions, sales charges, market impact costs and direct trading costs.

Like other assets, passive funds also carry opportunity costs, creation and redemption fees, and taxes on interest income and capital gains.

Passive fund closures

Despite increasing investor interest, plenty of passive funds fail to garner enough money to cover their operating costs. In the event that a passive fund cannot remain profitable, it will close or merge with a similar product. This could expose an investor to reinvestment or tax risk.

Conclusion

Setting an investor’s long-term investment strategy and overall risk tolerance are the two most important ingredients when investing. Neither active nor passive funds are the holy grail of investing, and both have their pros and cons.

Active managers rarely outperform consistently and will experience ups and downs.

Similarly, passive funds tend to benefit when markets are up and suffer when markets are down. Research has consistently shown that active and passive strategies complement each other well in multi-asset portfolios, but investors who strongly preference one over the other are more likely to have a less rewarding investing experience over the long run. Investors in passive funds may be attracted by the idea of self-reliance and lower costs (than active investing), but they should still be prepared to do a lot of research before informed investment decisions can be made on a regular basis.

Failure to understand the eight risks detailed in this article, could lead to disappointment and surprise further down the line.

Important Information

Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at  December 2017. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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