Active vs. Passive in the U.K.—A Follow-up

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A few weeks ago, we published this article about the dismal performance of active managers in the U.K. We saw that only 1% of them were found to reliably beat a risk-adjusted benchmark, but even for that 1%, the managers extract the whole of this superior performance for themselves, leaving nothing for investors. At the conclusion of that article, we expressed our hope that this would be a tipping point for the U.K. where we would see a large migration from active to passive, as we have begun to see here in the U.S.

We believe that we have found further support for a U.K. tipping point in this beautifully-written article from The Economist. While the focus of the article is more about the squeezing of the global investment management industry, as detailed in this fascinating report from PwC on what asset management will look like by 2020, it contains many important points about the emergence of passive investing in the U.K.

The first of these is the introduction of the retail distribution review (RDR) in 2013 which abolished commissions paid from fund companies to advisors and required advisors to explain the true cost of advice to clients. Clearly, this would give advisors a strong incentive to move toward lower cost funds. Here is a nicely done video from Morningstar’s UK Website that explains RDR in greater detail. The PwC report expects more countries to enact similar changes to better align the interests of advisors with their clients.

The second trend driving the move to passive is the rise of alternative indexes which the authors refer to as “smart beta”. In the UK, Dimensional Fund Advisors (DFA) is considered a leader in smart beta, but they (and we) prefer to call it “scientific investing”. DFA's foray into Great Britain has met with great success. As of 6/30/2014, DFA has $25.7 billion of assets domiciled in the UK. This represents a 15% increase over 12/31/2013 and a 36% increase over 12/31/2012. A highly informative four-part video series on the topic of smart beta featuring interviews with luminaries of the investment world was created by Sensible Investing TV which is connected to a UK investment advisory firm. We have found all of their videos to be worthy of our time. The authors of the article trace the evolution of the role of science in finance:

“A hundred years ago they [institutional investors] regarded all returns as evidence of a manager’s skill. Then they began to compare returns with those of other managers or the market. Later, with the help of academics, they realized that fund managers might beat the market by taking more risk; so they started to use risk-adjusted measures. Then they realized that outperformance might be down to fashion: the manager might have had a big exposure to, say, value stocks that had been doing well in recent months; so they began to attribute managers’ performance to factors such as cheapness or exposure to smaller companies. All this has narrowed the scope for managers to demonstrate skill, rather as Victorians explained more and more natural phenomena in terms of science, rather than divine intervention.”

The third trend is the on-going shift from defined benefit to defined contribution (DC) retirement plans. Since the latter are heavily scrutinized for their costs, indexing provides a sensible option. The authors note that since the average large British company has costs of 0.41% on it DC retirement plan, there is not much room for high cost active funds. More than half of these plans in the U.K. use tracker funds (i.e., index funds) exclusively. Clearly, this is another trend that is equally applicable to the U.S.

Two counteracting forces to these trends toward passive are the hope that some investors have that they will find the right active manager who will deliver benchmark-beating performance and the inertia of investors who have already sunk money into actively managed funds. Some investors may want to transition but are impeded by the cost of switching, and other investors simply may not care whether or not their funds have lagged their benchmark.

One term used throughout the article that we do not fully agree with is “commoditization” as it relates to fund management. It would seem to imply that anyone with capital and computers can create and maintain an index fund. We know that there is a great deal of thought and research that goes into running a family of passively managed funds that effectively capture the various risk and return dimensions of the market. To learn more about Index Fund Advisors’ approach to building portfolios consisting of index funds across many different asset classes, please give us a call at 888-643-3133.