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City fund managers are under more pressure to outperform than they used to be thanks to passive products

The rise in popularity of passive funds could be a blessing in disguise for stock-pickers


Passive investment products of various types have seen a rise in popularity over recent years thanks to a combination of booming stock markets since 2009 and falling fees.

With exposure to the main share indices such as the FTSE 100 and many others being available to investors for as little as 7 basis points (0.07 per cent), more and more people have been putting a larger chunk of their investment pot into them.

Passive funds represented 27 per cent of total funds invested worldwide in 2017, up from just 16 per cent in 2010.

City fund managers are under more pressure to outperform than they used to be thanks to passive products' rising popularity and lower fees

City fund managers are under more pressure to outperform than they used to be thanks to passive products’ rising popularity and lower fees

The other side of this coin is that it has eaten into the amount of money being put into actively managed funds run by stock-pickers, and is forcing them to lower fees, which in most cases still remain at least ten times higher than the cheapest passives.

On the face of it, this ongoing development in the investment marketplace is bad news for stock-pickers and the firms that employ them.

There is another side to this however, that means an increased market share for passive funds could bring some benefits to active management firms, and ultimately to investors.

French investment firm Lyxor has sponsored some research into the impact the rise of passive funds is having on the stock market. The paper produced by academics at Paris-Dauphine University is titled ‘What role has passive management left for active?’

It examines whether the increasing market share of passives will generate inefficiencies for stock-pickers over on the active management side to exploit.

One of its central conclusions is that the increased role of index-based investing is in fact ‘more an opportunity than a threat for active managers.’

There is an important caveat. This being that it is only a good thing for active managers that generate alpha, or in other words do what they are supposed to do and beat the relevant share index. 

According to the research, benefits stem from active funds that do not generate consistent alpha increasingly being forced out of the market, leaving more money to go into the ones that are performing.

Those undershooting the market consistently while charging ten times as much as a tracker have less and less chance to get away with it. This helps reward fund firms that have genuinely good products, and is good news for investors as they will be less likely to end up in dud funds. 

As well as this broad brush benefit to the investment market, there are some specific benefits to stock pickers that are left in the game still. 

The Paris-Dauphine researchers found evidence to suggest increased benchmarking reduces the number of shares in investors’ portfolios that are ‘sensitive to private information’, and limits investors’ willingness to speculate.

That is to say the higher passive market share means there are less investors of all kinds seeking out stock specific information to act on, the paper explains. Fewer people are trying to ‘beat the market’ in the first place.

This means so-called ‘informational efficiency’ declines in the stock market – the measure of how equally relevant knowledge is spread among all participants in the given market.

Given that outperforming the market – generating alpha – depends in large part on there being unequal information among market participants, this creates greater opportunity for fund managers to outperform their benchmark index.

In turn, if this holds true it means that over time investors who put money into the active funds left still in business are more likely to be getting what they paid for.

 



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