A spike in the number of US index trackers and a major gap between the performance of passive funds are some of the key findings in this year’s annual BMO GAM Multi-Manager PassiveWatch study.
The PassiveWatch report is a yearly review of the passive investment industry, identifying investment trends and comparing the performance of passives relative to actively managed funds.
The study covers seven sectors: UK equities, Europe ex UK equities, US equities, Asia Pacific ex Japan equities, Japan equities, global emerging market equities and sterling corporate bonds.
Below are the five main trends identified in BMO’s latest analysis.
Active management beats passive in the US for the first time in study’s history
The first finding is that the best active manager beat the best performing passive fund over a 10-year period in the US market for the first time since the PassiveWatch study began in 2014.
The fund beat the passive option by a “substantial” 120 per cent. The US market is notoriously one of the hardest markets to outperform as it’s extremely well researched and highly liquid, which the study recognises.
Looking at the other sectors and only in global emerging markets did active fail to outperform passive over the 10-year time horizon.
Improved active opportunity in the US
As stated above the US equity market historically has been difficult for active funds to outperform in. But, according to the study passive funds in the US have not been doing so well.
The study looked at the average performance of passive funds in each sector over a rolling five-year time horizon. In the US the average passive fund has usually made top-quartile returns but this has now changed.
BMO said: “The trend is now less favourable for the US market, showing active managers to have had an improved opportunity of late.”
According to the report, other sectors saw a wide dispersion of passive funds’ average performance and trackers have strengthened in some areas.
One of the most notable was in the European sector, where the four largest passive funds had ranked in the 71 percentile for five years to the end of Q1 2016.
But since then European passive funds surged to the 35 percentile, which the study said was an indication that these markets have recently been a “tough” environment for active investors.
The best between best and worst passive return grows
Another key finding from the PassiveWatch report was a “huge divergence” in the returns of passive funds.
The sectors with the biggest gap between the best and worst passive funds were the US equities and global emerging market equities, with a 57.5 per cent and 60.4 per cent gap respectively.
BMO added that this divergence between the returns available demonstrates different options to the passive fund buyer, suggest that the increased variability in returns is often due to country or style indices.
This means the ‘active’ passive fund buyer is presented with an opportunity for enhanced returns through fund selection,
Rob Burdett, co-head of multi-manager people team at BMO Global Asset Management, commented: “Our analysis strongly pointed to a trend of growing disparity in the range of performance between the best and worst passive funds, which is determined by the choice of index benchmark, charges, dividend policy, gearing, currency and tracking methodology.
“This divergence highlights the opportunity for the ‘active’ passive fund buyer, while allowing investors to efficiently manage costs while adding diversification. Our analysis however identified some emerging trends which are more favourable to active managers, particularly in the US. Against this backdrop, we are currently at the lower end of our historical passive exposure across our Multi-Manager Lifestyle fund range.”
The idea that there is such a wide gap between the return of passive funds in the same sector may seem counterintuitive.
But as the BMO GAM report explained, there are several reasons why this will happen. Mainly because of the ‘tracking methodology’ used - be it full replication, stratified sampling, optimisation or synthetic replication - but also around what fees are charged and ‘cash flow management’.
Best active managers outperformed every market over the past 20 years
The study also looked at how vast the outperformance between the best active funds and the average passive funds were in each sector.
The report excluded both the global emerging market equities and corporate bonds sectors because there were no passive funds with a 20-year performance record in either.
The difference in performance between sectors was significant.
Taking the UK as an example, the report found that the best performing active fund beat the average passive 7.2 times over on a 20-year time scale. In Japan the active fund was 4.7 times better and in Asia the best fund delivered double the return of the average passive fund.
According to the study: “The observations in the scale of the outperformance of the best performing fund are striking.”
“In summary, in every market it would have been worthwhile identifying the best active fund in the market, rather than passive.”
US overtakes Japan with highest proportion of passive funds
The report’s final key finding was that the US equities sector replaced Japanese equities this year for the highest proportion of passive funds.
According to the report the S&P 500 is the most tracked index. It said: “We are unsurprised by the US market regaining top spot given it is the birthplace of passive fund management, and it remains a hotbed of passive fund innovation.”
The amount of passive funds in the industry overall has been on a consistent rise.
According to data from the Investment Association (IA) the retail sales of passive funds to end of November 2020 were £17.5bn, an increase of £1.2bn from 2019.
The report said: “Passive funds continued to take market share from active managers at a growing pace, but with less than 20 per cent of the total Investment Association assets in passive funds, there would appear significant flows for passive managers to still aim for.”