You can’t eat beta

Whatever the question, passive, it would seem, is the answer – at least in today’s fund management industry. Regulators, the media, consumer groups and Warren Buffetophiles have all fallen head over tip-sheets in love with passives. The argument runs that passive funds are both cheap and simple to understand, whereas active has underperformed, is opaque and expensive. It therefore follows that the obvious way to build trust and engage with retail investors is to push for passive. What’s not to like?

Well, for a start, it has been suggested that passive managers, not content to merely grab industry market share, may be actively plotting the downfall of capitalism itself. More seriously – and before you lose too much sleep over the inherent contradictions of the passive-investment system – there is perhaps a more pressing question to be examined: does passive actually provide retail investors with what they want or need?

The question of clients’ needs is, of course, a tricky one. We can eliminate part of the equation with a quick look at what we know they don’t want. After all, whatever the itch that needs scratching, goal-based investing comes with a large inbuilt limitation: volatility is a big no-no. While long-term investors may prove willing to weather most storms, investors seeking income or steady returns are unlikely to hang around for long when the market is a-dropping. In fact, buying patterns show that retail investors have an uncanny ability to time the market in order to buy the highs and sell the lows – the investment equivalent of entering the building through a top-floor window only to fall straight down an open lift shaft. And, unfortunately, this is not a phenomenon we are likely to see change much in the presence of simpler or cheaper products.

Thus, catering successfully to retail investor needs (and, incidentally, keeping them invested) requires managing volatility, or at least accepting that some investors, such as those in pension drawdown, will be unable to tolerate it. This brings us to some of the problems associated with the passive retail push. On the one hand, passives, having full beta exposure, will experience periods of real volatility as underlying markets fluctuate. On the other, many investors need products with outcomes – something passives are incapable of providing, focusing as they do on an input, ie an index. At the end of the day, an index is an artificial construct which does not meet any specific needs.

To be clear, I am by no means an enemy of passive or an outright supporter of active. Not at all. Passive funds are making investing cheaper for many and, for those able or willing to ride the waves of volatility, it can be a great option. Likewise, there is too much active which fails to deliver, is too expensive and fails to protect investors in a downturn. Nevertheless, it has to be pointed out – perhaps, in the current press climate, more emphatically than ever – that passive is not the panacea for every investor’s needs. The rush to plonk retail investors into passive ignores the very real risk that, faced with a downturn, volatility and negative returns simply prove intolerable; cheap fees cannot compensate for full market exposure if the latter simply pushes investors towards the door. While it’s admirable to focus on getting the best deal for retail investors, there is little comfort – or profit – to be had from the exhilarating lift-shaft experience described above. Retail investors deserve better if they are to be converted into long-term investors and supporters of the industry – when markets fall, they can’t eat beta.