Welcome to the 9th 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 2022.
This edition’s analysis includes:
- Industry news – passive fund developments which have caught our eye.
- Tops and Bottoms – a look at the range of performance of passive funds in the main Lipper Global sectors during 2022.
- 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.
- Aspects of Selection – things to be aware of when selecting passives (smart beta, methodology, tracking error, costs, stock lending etc).
- The CT Multi-Manager View – how we do and don’t use passive.
Executive Summary
- Within Industry News, we highlight why Turkeys voted for Christmas last year, question the fairness of passive funds holding the Tesla airbag and why we give a thumbs down to single-stock ETFs.
- 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, leverage, 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 63% range! This is the largest range of passive returns within a market for five years.
- Within ‘When was a good time to use passive’ we review when passive funds achieved relative success within each market over the past ten years.
- 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 2002 there were a total of 89 passive funds. By the end of 2022 this had grown to 499, a more than five-fold increase.
- Once again, we suggest an ‘agnostic’ approach is one 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.
Industry News: A review of passive fund developments over the last 12 months
Turkey’s voting for Christmas
You could be forgiven for thinking Turkish equities would not feature regularly in our annual review of passive funds, particularly as investors would have lost 40% of their money over the past decade(!) if investing in MSCI Turkey index.
2022 was the year Turkish equities came roaring back, with passive Turkish products taking all top ten spots in the coveted CT Multi-Manager Global Passive Fund Leaderboard (not trademarked).
With annual inflation hitting 85% (that is not a typo) in Q4 2022, local investors poured their money into equities to try and preserve purchasing power, driving up the returns of the local stock market to generate a return ranging between of 127% and 155%. A niche but surprisingly profitable investment last year.
Highly Commended goes to ProFunds for their Oil & Gas Sector ETF range which also generated returns in excess of 100% in 2022. It wasn’t too long ago that we covered the woes of oil and gas ETFs when the oil price fell below zero in 2020.
At the opposite end of the global leaderboard were funds tracking the UK gilt market. The selloff following Prime Minister Truss and Chancellor of Exchequer Kwarteng’s mini-budget sent some products which use derivatives to generate their exposure to new lows for the year, with five funds losing at least 90% of their value.
We discussed the gilt market ructions in a podcast back in October with Allianz Global Investors bond manager Mike Riddell.
Passive funds left holding the Tesla air bag
The meteoric rise of Tesla Inc over the past decade has been a troublesome one to capture for passive fund managers. Despite being listed on New York Stock Exchange since its IPO in 2010, the company did not qualify entry to the primary S&P 500 index until 2020 due to its loss-making characteristics.
After posting four consecutive profitable quarters Tesla entered the S&P 500 on 21st December 2020 at a whopping $500bn market cap and off the back of 1,300% performance over 5 years! Tesla’s market capitalisation as at 2022 year end was around $375bn and performance since entry has been -43%.
If companies are able to stay, on paper, unprofitable for longer and grow their economic value, it raises questions around whether the criteria for index inclusion can lead to inequitable outcomes for investors.
In addition, with profitability flagged well in advance to investors and passive fund providers forced buyers on a particular date, is it fair that non-index funds are able to own the shares in advance, knowing there will be a large purchase from a particular date onwards? Either way, passive fund owners seem to be left holding the Tesla’s proverbial air bag in this scenario.
Meanwhile, it’s healthy to see the S&P 500 index diversify somewhat after beginning the year with 23% of market cap in its top five stocks, to only 18.8% by year end. We note the long term average of the top five stocks is only 13.5% over the long term, meaning the index is still more concentrated than historically. Interestingly, Tesla dropped out of that top five and was replaced by prestigious investor Warren Buffet’s Berkshire Hathaway; perhaps a cute metaphor for 2022 performance.
Largest S&P 500 Stock Weights
Source: Factset
ARK Innovation – inflows defying gravity. Performance less so
Readers of this annual will know we’ve had a bee in our bonnet about active ETF manager ARK Innovation for a number of years now. Whilst performance dropped substantially through 2022, the penny did not seemingly drop for investors. The flagship ARK Innovation ETF saw shares outstanding grow by 15%, some $1.5bn of fresh money in since the start of the year, in the face of a 60% decline in performance, wiping out gains over the previous five years. The buy-the-dip strategy which has worked well for investors in the bull market of the past decade has now left many under water.
Miner the gap. Crypto suffers, commodities soar
We discussed the perils of owning Bitcoin in our 2022 Passivewatch as a result of the ProShares Bitcoin Strategy ETF launch, citing the two 90% drawdowns in the previous five years. ‘It’s Happened Again’ is usually a chant thrown between rival football fans after a derby day comeback, but it seems appropriate with Bitcoin value falling -60% in 2022. Bitcoin mining may not be nearly as lucrative with crypto having a terrible time of late.
On the flip side, many traditional resources-based passive funds featured in the top decile of performers in 2022. Commodity prices were already elevated post-COVID and were further lifted as a result of supply worries post Russia’s invasion of Ukraine. We suggest choosing your miners carefully, with resource miners able to generate superior market returns when commodities and energy supplies are threatened.
With gold usually seen as a safe haven asset in times of market stress, it’s interesting to see Global X launch Europe’s first pure-play silver miners ETF in May. It mirrors their successful $1bn strategy in the US and adds to Global X’s growing stable of ETFs available to European investors. Perhaps they hope ‘all that glistens is not gold’ holds true for investment purposes.
Single stock ETFs are a no from us
Each year sees market ‘innovation’ and this year’s phenomenon seems to be the launch of single stock ETFs. Yes, you guessed it, an Exchange Traded Vehicle to track the performance of just one company at a time. Although seemingly innocuous, retail investors beware. Not least would we not advocate such concentration in one single company, diversification is a free lunch after all, such products often come with leverage meaning investors magnify stock returns in either direction, inducing short term trading. Unless investors have the time, skill, and information to use these products, which have complex risks associated, we would recommend staying clear.
Investors should use a passive fund for cheap access to broad market returns or use an active equity manager to potentially generate returns in excess of the market, albeit usually for an increased fee.
Interesting product launches
Observing the exotic launches of the passive fund world is increasingly becoming a favourite pastime of ours. Whilst we aren’t quite screaming adoring fans just yet, we found it amusing to see CT Investments (not related to Columbia Threadneedle Investments!) launch their K-pop ETF. The ETF tracks a basket of Korean entertainment stocks which aim to benefit from the growth of K-pop industry. It’s safe to say we won’t be ticketholders for this one.
Continuing the theme of actively managed sustainable ETFs of the past few years, Emerge Canada released a range of ETFs which are sub-advised by female portfolio managers. Emerge note female portfolio investment managers tend to be underutilised and underrepresented and are keen to promote otherwise. In addition, any company selected for inclusion must rank in the top half of its universe according to Emerge’s sustainability score, while the portfolio itself must have an aggregate sustainability score in the top third.
Lastly, Tuttle Capital Management caused a stir when they filed to launch two ETFs to track the recommendations of celebrity analyst Jim Cramer. The CNBC Mad Money host is well known for his gregarious market opinions, which are of mixed success, and investors can soon decide to follow his ideas through the Long Cramer ETF, or shun them, through the Inverse Creamer ETF – actually shorting his stock recommendations! Whilst humorous from the outside it’s probably best to just watch the show than use hard-earned savings betting for or against a TV show host’s pick of the day…
Highs and lows – a look at the range of passive performance in the main Lipper Global sectors in 2022
Highs and lows of passive returns in 2022
Source: Lipper for Investment Management
The returns above are for passive funds only, showing the best and worst passives over one year. The dispersion ranges this year were the most pronounced since our studies began. In last year’s publication, we highlighted the Bond GBP Corporates sector range at a mere 5.3%. In 2022, the range blew out to a mammoth 28.3%, reflecting the dispersion in the returns driven by duration within fixed income. However, the largest dispersion of returns within the review show, once again, the Equity US sector with a range of 62.9%, once again highlighting the importance of carefully choosing the index you want and a good passive manager. The smallest spread of returns was within Equity Europe sector, where returns ranged a mere 13.6%, still a large number in our opinion but the narrowest of our study.
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.
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. The former was led by a NASDAQ 100 ETF and the latter being won by the FirstTrust Chindia ETF, a passive fund providing sole exposure to Chinese and Indian technology stocks. Interestingly both of these funds had challenging 2022 performance, yet their returns for the nine years previous was still enough to take top place. Post year end FirstTrust announced they were closing their top performing ETF – somewhat surprising considering the long term performance.
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
Source: Lipper for Investment Management
When was a good time to use passive?
We took the largest four passive funds by AUM for each sector, as at 2022 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.
It’s striking that the volatility of the passive funds has been quite high through recent periods for all of the major indices. For instance, the four largest GBP Corporate Bond passive funds ranked as low 78th percentile for five years to the end of Q2 2022, but has since has surged to finishing 36th percentile. The hardest place for active management has consistently been the US market, where the average of passive funds has mostly been top quartile over each of the five-year windows reviewed. Equity Asia has seemingly been a fertile ground for active management with the passive average mostly below 55th percentile.
Rolling Passive Percentile rank
Source: Lipper for Investment Management
Returns over a 20-year period
We reviewed six markets and identified the ‘Best Fund Overall’, which could have been either actively or passively managed. Five out of six markets observed saw the best fund being an active fund.
Only the US market is an exception. Equity Europe ex UK saw the greatest multiple of outperformance – with the best active fund outperforming the best passive by 2.7x. The lowest multiple of outperformance was in US equities, where in fact the best passive fund outperformed the best active fund by 1.1x. The Best Overall Fund in US equities was the Invesco QVM ETF, a passive fund which tracks a market with concentrated exposures
to Quality, Value and Momentum-orientated securities.
The second lowest multiple of outperformance achieved was in Bond GBP Corporates where the best active fund outperformed the best passive by 1.3x, although investor choice was limited to a single passive fund which was available for the whole twenty year period. In each market, the best fund overall materially outperformed the broad reference index.
We’ve included the median active fund performance over this time and median passive fund to compare further. The results are more favourable for passive managers, with the median active fund outperforming the median passive in only two of the six markets – UK and Equity Europe ex UK.
Finally, the broad reference index has outperformed the median active fund in each market, highlighting the importance for investors to identify high quality active investment managers. The median passive fund has also underperformed the broad reference index1 in five out of six sectors, although this is to be expected when comparing fund returns on a net of fees basis.
20 year returns
Source: Lipper for Investment Management
Passive fund growth
According to the latest available figures released by the Investment Association, retail sales of passive funds in the year to the end December 2022 were £10.3bn, on course to be almost 40% lower than 2021 flows. Their overall share of industry funds under management rose to 20.8%, even if total AUM of £289.4bn, representing a feature of negative market performance than flows.
Despite mostly negative market returns in 2022, the strength of markets over the past decade have led to significant flows into the passive fund sector. Passive funds continued to take market share from active managers, yet only one-fifth of total Investment Association assets are currently passively managed. It would appear there is still a large slice of the overall pie for passive managers to aim for.
Passive funds assets under management (£m)
Source: The Investment Association, end Dec 22
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 1,763 funds in total registered for sale at the end of 2022 in the UK within these seven sectors, which is up slightly from 2021. Of this total, 499 were passive vehicles (457 last year), around 28% of aggregate number.
Of the 499 passive funds existing today within the seven Lipper Global sectors, 365 of them were in existence five years ago and 259 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 fourteen funds 20 years ago, to 155 to choose from today.
Number of passive funds
Source: Lipper Investment Management, end Dec 22
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 155 of its 424 funds (36%) passively managed, broadly consistent with the last few years. The sector with the lowest proportion of passive funds is Bond GBP Corporates, where 27 of 132 funds (20%) were passively managed.
We are unsurprised the US market remains top spot given it is the birthplace of passive fund management, and it remains a hotbed of passive fund innovation. Whilst the S&P 500 remains the most tracked index in US, the rivalling proportion of passive funds in Japan is more attributed to the market there having two well-known indices to track, Nikkei-225 and Topix, which leads to a disproportionate number of tracker indices on offer.
Consistent with last year, there remains a huge number of indices being tracked. If we look at the UK for example, although the two most common indices are the FTSE 100 Total Return and FTSE All-Share Total Return, there are a further 18 indices being tracked.
Passive funds as a proportion of sector
Source: Lipper for Investment Management, end Dec 22
Indices per market
Source: Lipper for Investment Management, end Dec 22
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 600+ 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 rules-based 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.
The CT Multi-Manager 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 MM Lifestyle portfolios for example, between 16–23% 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.
CT MM Lifestyle 3 | CT MM Lifestyle 4 | CT MM Lifestyle 5 | CT MM Lifestyle 6 | CT MM Lifestyle 7 | |
|---|---|---|---|---|---|
Number of Passive Holdings | 6/30 | 6/36 | 5/38 | 3/36 | 3/32 |
% of Passive Exposure | 23.2 | 18.2 | 18.1 | 16.5 | 18.6 |
