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Passive investing – growing list of considerations

17 November 2020

Investing in passive funds is not as straightforward as some investors may think and still requires investors to do their homework, says Quilter fund expert Nick Wood.

The first half of this year saw continued outflows from active funds, but the UK witnessed strong inflows into passive funds. But, Wood says, while passive funds can often beat their active rivals on both price and performance, investors should not be under the impression that every index is the same.

“Whilst passive investment would seem to take away the difficult decisions around selecting an outperforming manager, there are still a number of factors investors need to consider to get the best outcome.

“Even in this area, there continue to be enhancements to how they are managed and created by fund groups. For example, we have seen BlackRock branch out into the synthetic ETF space.

“That said, as passives become increasingly part of the investing landscape, there is a growing list of considerations that need to be taken into account, and as such research is becoming vitally important.”

According to Wood, investors should carefully consider the right index, with small differences in indices such as a slightly broader set of constituents including smaller companies or the use of alternative index providers having a meaningful impact.

ESG has become a growing part of the investment market and for investors seeking a more ESG-focused manager, Wood recommends looking at how much the manager engages with the underlying company holdings on behalf of investors.

Wood says: “Clearly a small number of passive groups manage a huge amount of global capital and have significant influence and choose to use this to a greater or lesser degree. Like active managers, some passive providers continue to up their game in this regard, not least due to external pressure from investors.”

Investors should also consider whether they are better suited to physical or synthetic ETFs, with the latter potentially riskier, especially in more illiquid markets.

Wood explains: “Synthetic ETFs have certain tax advantages over their physical counterparts, but one might argue that for a few basis points, the potential risks and complexity of such a product just isn’t worth the switch.”

Indeed, cost should be a key consideration for investors when choosing a passive fund. While passive funds have fallen steadily, Wood warns there can still be “meaningful disparity” between products.

Wood adds: “It’s also noticeable that as active fees decline, in some areas where passives are a little more expensive, the active alternatives can sometimes get a lot closer to passive fees than they used to.”

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