Welcome to the 8th annual edition of CT Multi-Manager PassiveWatch, an annual review and analysis of the passive fund industry. All data is from Lipper Global sectors and is calculated in total return terms in sterling for periods ending 31st December 2021.
This edition’s analysis includes:
- Tops and Bottoms – a look at the range of performance of passive funds in the main Lipper Global sectors during 2021.
- A decade of active and passive investing – a decade is a long time horizon.
- How did passive investing get on and when was a good time to use it?
- 20 Years – how have both active and passive funds compared over the longer term?
- Passive Popularity – a review of passive fund growth and which sectors were most popular.
- Industry news – investing passive developments that have caught our eye.
- Aspects of Selection – things to be aware of when selecting passives (smart beta, methodology, tracking error, costs, stock lending etc).
- The CT Multi-Manager People view – how we do and don’t use passive.
Executive Summary
- As usual, there is a vast range of performance between the best and worst passive funds due to the choice of index benchmark, charges, dividend policy, gearing, currency, tracking methodology and other features. For example, over just one year the best and worst passive funds in the Lipper Global Equity – Equity US sector performance spans a 41% range!
- The huge growth in the number of passives continued, increasing their influence on the average fund returns. Across the seven market groups we survey, in 2001 there were a total of 76 passive funds. By the end of 2021 this had grown to 457, a six-fold increase. The returns above are for passive funds only, showing the best and worst passives over one year. The dispersion ranges from only 5.3% in the Bond GBP Corporates sector to 41.2% in the Equity US, highlighting the importance of choosing the index you want and a good passive manager. In fact, the average range between the best and worst passive return across was 22.3% – a 10% narrowing compared to the 2020 data. This divergence between the returns available demonstrates different options to the passive fund buyer. When we delve deeper into each Lipper Global sector, we find that this increased variability in returns is often due to country or style indices, highlighting the opportunity for the ‘active’ passive fund investor.
- The best active equity managers have delivered as much as five times the average passive fund over twenty years.
- 2021 was the year of supply chain disruption and the shipping market underpinned the best ETF returns, with the 2021 laggards largely made up of 2020s biggest winners. See p6 for details.
- An ‘agnostic’ approach that accepts that, over any sensible investing period, both can play a role at different times for different markets would seem to be underpinned by the data.
1. Tops and Bottoms – a look at the range of passive performance in the main Lipper Global sectors in 2021
Best & worst passive returns per sector in 2021
The returns above are for passive funds only, showing the best and worst passives over one year. The dispersion ranges from only 5.3% in the Bond GBP Corporates sector to 41.2% in the Equity US, highlighting the importance of choosing the index you want and a good passive manager. In fact, the average range between the best and worst passive return across was 22.3% – a 10% narrowing compared to the 2020 data. This divergence between the returns available demonstrates different options to the passive fund buyer.
When we delve deeper into each Lipper Global sector, we find that this increased variability in returns is often due to country or style indices, highlighting the opportunity for the ‘active’ passive fund investor.
2. A decade of passive and active investing
Over the past decade, the range of performance for both passive and active is shown below. From this we can see, as perhaps expected, there is a smaller range of performance for passives, while the highest performers in the active world are almost always very significant outperformers and well worth trying to identify, such is the case in five out of the seven sectors analysed.
The only sectors to buck the active trend were the US and Global Emerging Markets – with the latter being won by the FirstTrust Chia India ETF, a passive fund providing sole exposure to Chinese and Indian technology stocks, yet again outperforming all active funds but at a much reduced margin than the ten years to 2020. Coincidentally, the worst return available in the market was also a passive fund.
Currency hedging can account for much of the difference in returns in some sectors, with leveraged ETFs a factor in some others and sector biases too, such as NASDAQ. Selecting the appropriate index and analysing the costs of the product as a starting point is an obvious but important point to ensure the required market exposure is being taken. The method of tracking and tracking error are also important, something we review later in this paper.
A decade of passive & active investing
When was a good time to use passive?
We took the largest four passive funds by AUM for each sector, as at 2021 year-end, and calculated a simple mean of their percentile rank on a rolling five-year window, to try to understand when passives outperformed their respective Lipper peer groups and when they did not. The results revealed a still wide but narrowing dispersion between the sectors.
However, the trend is now less favourable for the US market and, in fact, at 30th percentile the most recent 5-year period is the worst return for US passives.
Rolling passive performance
3. Returns over a 20 year period
We again reviewed both active and passive funds over a 20-year period. We had to remove Global Emerging Markets and Bond GBP Corporates from the analysis at this point as there were no passive funds on offer in these two sectors 20 years ago.
We compared the performance of the best fund in each sector against the average fund (both active and passive), the index*, the average passive return and the best passive return.
The most striking observation is the scale of the outperformance of the best-performing fund. In the UK sector, the best-performing active fund outperformed the average passive fund by whopping multiple of 5x! In summary, in every market it would have been worthwhile identifying the best active fund in the market, rather than passive.
20-year returns
Source: Lipper as at 31-Dec-21
4. Passive fund growth
We compared the performance of the best fund in each sector against the average fund (both active and passive), the index*, the average passive return and the best passive return.
The record passive funds under management is hardly a surprise given the strength of all markets in 2019 and the continued flows into the sector. Passive funds continued to take market share from active managers albeit now at a decreasing pace. However, with less than 20% of the total Investment Association assets in passive funds, there would appear significant flows for passive managers to still aim for.
Passive fund growth
Source: Lipper as at 31-Dec-21
Sector Trends
As in each previous edition, we have spent some time analysing seven popular sectors within the Lipper Global universe and share the results below. We looked at growth in passives over 5, 10 and 20 years of data.
The seven Lipper Global sectors analysed were: Equity UK, Equity Asia Pacific ex Japan, Equity Europe ex UK, Equity US, Equity Japan, Equity Emerging Markets Global and Bond GBP Corporates.
There were 1,742 funds in total registered for sale at the end of 2021 in the UK within these seven sectors, which is down slightly from 2020. 457 of these were passive vehicles (451 last year), around 26% of the total.
Of the 457 passive funds existing today within the seven Lipper Global sectors, 355 of them were in existence five years ago and 220 were around ten years ago. The sector with the highest percentage growth in the number of funds available was Equity US, which has grown from nine funds 20 years ago, to 144 to choose from today.
Number of passive funds
Source: Lipper as at 31-Dec-21
In which sectors are passives most populous?
Out of the seven sectors we looked at, the one with the highest proportion of passive funds is still Equity US, with 144 of its 410 funds (35%) passively managed. The sector with the lowest proportion of passive funds is Bond GBP Corporates, where 27 of 136 funds (20%) were passively managed. However, this is up from 11% last year, representing the growth of credit market passive instruments available to investors.
Passive funds as a proportion of sector
Source: Lipper as at 31-Dec-21
Indices per market
Source: Lipper as at 31-Dec-21
5.Passive News: A review of developments we have noticed over the last 12 months
And the winner is… Investing in supply chain disruption
Out of the seven sectors we looked at, the one with the highest proportion of passive funds is still Equity US, with 144 of its 410 funds (35%) passively managed. The sector with the lowest proportion of passive funds is Bond GBP Corporates, where 27 of 136 funds (20%) were passively managed. However, this is up from 11% last year, representing the growth of credit market passive instruments available to investors.
Breakwave’s Dry Bulk Shipping ETF tracks the price of dry bulk freight futures – in simple terms, the price of shipping commodities or large cargo, a cost that spiralled as economies tried to catch up on lost output post-lockdown. The fund returned a mightily impressive 277% through 2021, highlighting the price inflation for delivering goods worldwide.
If the providers require a snazzier name for its fund for marketing purposes, perhaps the ‘Breakwave Where’s My Stuff ETF?’ could be more appropriate. (No commission necessary.)
What goes up will often come down
Breakwave’s Dry Bulk Shipping ETF tracks the price of dry bulk freight futures – in simple terms, the price of shipping commodities or large cargo, a cost that spiralled as economies tried to catch up on lost output post-lockdown. The fund returned a mightily impressive 277% through 2021, highlighting the price inflation for delivering goods worldwide.
But what goes up will often come down. ARK ETFs on average returned a lousy -14.26% vs. S&P 500’s 30% return. Whilst the long-term performance records are still spectacular, the average dollar invested in these products will have unlikely enjoyed such stellar returns for the large majority.
It is anticipated the group will be launching products into Europe in 2022. Keep your eyes peeled.
We also highlighted the significant outperformance of funds tracking stocks linked to the transition to the green agenda, such as Invesco’s Wilderhill Clean Energy ETF. Unfortunately, the fund failed to match the bolder narrative on clean energy from governments that attended the COP26 summit. The fund lost 29.2% in 2021. Again, a reminder that ‘Capital is always at risk’ and popular investment themes can still produce lacklustre returns.
Cryptocurrency – interesting… but not for our portfolios
It is anticipated the group will be launching products into Europe in 2022. Keep your eyes peeled.
2021 saw ProShares finally secure clearance from the U.S. Securities and Exchange Commission to launch its ‘Bitcoin Strategy ETF’ – a fund designed to track the price of Bitcoin futures contracts, rather than the price today. Investors were obviously unconcerned by this important distinction, placing $1.4bn of assets into the fund in the first 30 days!
As an investment team, we continue to find Bitcoin and cryptocurrencies intriguing from an academic perspective and can see why investors find them attractive when central banks have actively tried to devalue their currencies. However, with Bitcoin suffering two 90% drawdowns in less than five years, we find the investment case too volatile to be considered a store of value. In blunt terms, it relies too heavily on a lucky entry or exit!
Long duration ≠ Low volatility
Passively investing in line with a broad-based benchmark of sovereign and corporate bonds has been a mostly winning strategy through most investors’ careers. However, the often-tracked Bloomberg Barclays Global Aggregate Index yielded its worst absolute return since 2005 at -3.8%.
One of the longest dated fixed income passive funds, the iShares 20+ Years Treasury Bond ETF, suffered its largest negative quarterly return of -14.8% in twelve years as investors began to rethink the outlook for growth and inflation in a recovering economy. However, with Covid lingering around for longer than expected, the fund recovered a lot of lost ground in the remainder of the year, finishing down only 3.9%.
6. Aspects of Selection – things to be aware of when selecting passives (methodology, tracking error, costs, stock lending etc.)
What factors can cause slippage in tracking or a high tracking error?
The biggest factors affecting the fund’s tracking error are the tracking method employed by the manager (discussed below), the skill of the manager to track the chosen index within the constraints of their methodology and the accrual of ongoing charges, including the management fee, of the fund.
When the tracking fund is set against an index that assumes no annual fees, the ongoing charges alone mean that the fund is destined to underperform. If we consider ongoing charges for passives within a typical range from 0.05% to 1.50% per annum, the impact of these different charges would compound over a 10-year period to 0.501% and 16.054% respectively, and to 1.005% and 34.69% over 20 years.
Another factor of tracking error to be considered is cash flow management (avoiding any potential cash drag/dilution caused by cash flow going into or out of a fund) – sometimes managers use index futures to minimise this effect, but as there aren’t many liquid futures contracts available (in the UK, the FTSE 100 contract is by far the most liquid), the replication may not be accurate, potentially causing tracking slippage.
Taxation is also a potential issue, including withholding tax on any dividends received on the underlying shares.
Tracking methodology
There are various different approaches that can be taken by a tracking manager to achieve a return similar to the index being tracked. Each of these methods have their own pros and cons.
1. Full replication
This method involves the fund holding all the stocks within the index in the same proportion as that index. For funds tracking the FTSE All-Share, this involves holding all 636 companies in the index. The main positive of this approach is that the resulting tacking error should be very low. Negatives include high costs due to the amount of dealing required to maintain the correct weights, particularly when factoring in illiquid stocks and changes to index constituents.
2. Stratified sampling
This approach involves buying the largest shares of an index in the same proportion and then holding a sample of shares from different industry sectors within the index, rather than holding every index constituent. The main positive here is that the dealing costs will be much lower as a result. Potential issues include the risk of a higher tracking error due to market cap and sector biases, or even stock-specific issues impacting returns verses the index.
3. Optimisation
Similar to sampling in that instead of holding all constituents of a benchmark, the manager holds a sample of stocks; different in that a sample of representative stocks are bought and when held together in a portfolio have similar risk/reward characteristics, and the mix is highly correlated to the index. This method is relatively cheap to construct but can result in a higher tracking error.
4. Synthetic replication
With this method, the manager does not buy the physical shares of a company in the index but instead enters into a swap arrangement with an investment bank. This method is important for asset classes such as commodities as it is impractical to buy the physical exposure. This method offers a low tracking error and typically low fees but does introduce counterparty risk as a potential drawback.
5. Smart Beta
Active managers through much of investment history have often been characterised by a style of investing, such as ‘Value’ or ‘Growth’. In recent years, systematic tracking strategies known as ‘Smart Beta’ have been increasingly used by investors to access these styles or factors.
However, investors should remember these are rulesbased products and are not likely to spot deteriorating fundamentals of underlying businesses, something that active managers are more accustomed to identifying.
Other things to be aware of:
Stock lending:
When considering a tracking fund, consider its ability to lend stock. This is where the manager would lend stock to a third party in return for a fee, which then gets paid into the fund. Whilst fees from this practice can add a few basis points of performance, there is an element of counterparty risk introduced which needs to be considered.
Not all asset classes are ideal for passive investing in our view:
- Property is one example of this. Whilst it is possible to track REITS and property equities, the same cannot be said of gaining passive exposure to bricks and mortar investments. One of the main characteristics and attractions of property as an investment is its low correlation to asset classes such as equities and bonds. This diversification benefit is more prevalent in bricks and mortar investments whereas property equities tend to be highly correlated (at least in the short term) to equity markets.
- Despite the huge rise in assets under management held in fixed income passive products, we still believe corporate bond investing is an area that is best obtained through a carefully selected active manager. This is primarily due to the construction of the passive indices, which often mirrors the rules of an equity passive fund, wrongly in our opinion. For instance, in a passive equity fund, when a stock price rises and the company is considered larger, all-else-equal, the larger proportion of the fund it comprises. Winners are therefore rewarded. However, in many credit passive funds the largest security tracked is often determined by the amount of debt outstanding. As a result, businesses with the most leverage outstanding are often those most highly tracked – not a characteristic that we necessarily want our portfolios to be exposed to.
7. The CT Multi-Manager People View – how we do and don’t use passive products
Many investors chose exclusively between holding passive or active funds, often citing the higher fees of active funds as off-putting. We have always held the view that if you pick the right active fund, the excess performance should easily compensate for the extra 50bps or so of annual cost. After all, the net returns (performance after fees & costs) of an investment are what ultimately matter to the client, rather than just the annual management charge.
However, we do believe that passives can have an important role to play as part of an overall portfolio (primarily as a means of reducing overall cost and adding diversification). We also recognise that they are destined to underperform the index they are designed to track – a function of fees levied over time and tracking error.
How do we use them?
Within our CT Multi-Manager Lifestyle portfolios for example, between 14–22% of the portfolios are exposed to passive vehicles, with the remaining three quarters in carefully selected active funds that we would expect to outperform an index over the medium to long term. Our passive exposure is largest in Lifestyle 3, which has the greatest proportion of government bonds – a sector that is notoriously difficult for active managers to add value
Passive funds as a proportion of sector
Source: Columbia Threadneedle Investments as at 31-Dec-21
