Research finds passive funds are to increase in usage by 6% per annum at least until the end of the decade. James Phillips explores the reasons behind the increasing shift
Passive fund management will continue to increase in usage over the next few years as pension schemes seek what they perceive to be better value for money when investing.
On average, these funds are set to see subscriptions increase by 6% per annum in the years to the end of the decade, with some schemes seeking to increase their allocation to these funds by 15% or more.
This is the case across defined benefit (DB), defined contribution (DC), and hybrid schemes in both the public and private sectors.
These are the findings from consultancy Create-Research which, with Deutsche Bank's asset management arm DWS, surveyed 153 pension schemes across 25 countries with combined assets of almost €3trn (£2.7trn). The analysis also includes structured interviews with senior executives at 30 plans.
Presently, two-thirds of the schemes surveyed already have mature passive allocations, representing a mean average of 32% of assets, according to the research.
Of these, 48% of funds use traditional indexed funds, while 38% use segmented accounts, and 23% use exchange-traded funds (ETFs). Across the portfolios included in the survey, these accounted for, as a mean average, 22%, 21% and 7% respectively.
Within these, 82% of passives cover equities, 54% cover fixed income, 20% are for multi-asset, and 13% and 7% are commodities and real assets respectively.
These come after a decade of growing use of passives, something Create-Research chief executive and report author Amin Rajan described as an "outstanding phenomenon" but leading to "alarming predictions" about the future of active funds.
Indeed, DWS chief executive Nicolas Moreau added: "Some observers might look at the last decade's rise in the market share of passive funds and conclude this is a sign of the failure of active fund management, but I don't see it that way.
"What we have seen is a fundamental reshaping of asset management, with some strategies standardised and made easily accessible at low cost, with the result that investors now have an unprecedented level of choice."
With no signs of abating, the use of passives is becoming increasingly popular, but the size of the growth among schemes is mixed. While four in five schemes have an increase planned, 15% seek growth of over 10%, while 49% say it will be below 5%. Another 8% say they will decrease their usage.
Kempen Capital Management UK head of investment strategy Nikesh Patel argues the move to passives is largely driven by the concurrent reduction in equity exposure.
"There has been a refocus on the remaining smaller pots of equities - do you still have active managers or you do go passive?" he says. "In light of the reduced importance of equities, trustees have started go passive just because there's less of an impact from active management.
"When you had 70% in equities, it was really important to have the right managers. You spent a lot of time looking at who was good, who was bad, and who you want to give your money to. From a 'what matters to trustees' perspective, it's all about strategy. So when they were looking at reducing equity, they got rid of the active managers first."
Schemes are less likely to move into cap-weighted indices (49%) or other thematic strategies (57%), with both of these areas likely to see a downtick.
Nearly 80% said their use of smart beta or factor-based strategies would grow, compared to 74% who will shift more into passive environmental, social and governance strategies.
Patel recognises the greater allocation to smart beta, noting developments in the products and the continuing selling down of active equity mandates improves their favourability.
"Trustees have had to decide either to retain the bog-standard passive or introduce smart beta," he says. "Over the course of 2009-2013, you saw a massive increase in smart beta products in UK portfolios. What's happening now is a shift from the pure passive market cap to passive smart beta."
Again, the reasons for switching are mixed; nearly three in five (58%) favoured low-fee products, while 55% cited strategic asset allocation.
Patel adds: "The approach trustees have had is, 'is it worth paying an active manager for something we can replicate passively?' and 'where am I going to get the most alpha for every penny I spend?' Increasingly, that leads them to say in alternatives of every flavour. They're saying that if they've got a fee budget, they'd rather spend it on these areas and save on the equities."
However, while just 10% believed passives will "displace actives" over time, another 60% saw actives and passives as able to "co-exist in a diversified portfolio as equal partners". The report said investors do not see passives as "an all-weather choice".
"Pension plans have adopted an eclectic approach that sees the world of investing as cyclical and self-correcting. Like the ocean tides, styles go in and out of fashion, making it essential to recognise the drawbacks of passives as well as their complementarity with actives."
Despite this, just over two in five (42%) said passives will permanently become part of funds' portfolios, with some also believing in a "Darwinian" battle where actives either have to innovate or adapt, or become irrelevant.
Nevertheless, passive equity funds do present potential risks from market corrections and volatility, as seen earlier this year. With many schemes having modelled this risk, Patel believes there are two further risks to note.
"There is a natural tipping point where the amount in passive starts to reduce the amount of research capacity of asset managers to price stocks correctly," he says. "If there weren't enough analysts covering the smallest company in the FTSE 350, the price quality of that company becomes poorer and, therefore, the passive money that is floating around betting on price might buy or sell that company based on bad pricing data.
"Another risk - which is a subtle one - is the sudden power the index provider has. There's a risk that the index providers do things which force investors to follow them, even if those might not be the things that investors wants."
He notes, for example, MSCI's decision to add Chinese stocks into its emerging market index this year. Analysts expect around $20bn (£15.1bn) of foreign inflows, mainly from passive investors.
The reduced use of active managers comes alongside UK pension schemes' reduced use of equities. While trustees are seeking low cost and value for money solutions, there are some potential risks that could grow over time as more and more schemes seek the passive route, and this is something that needs to be watched.
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