Passive march across Europe

by , 24th October 2017

ETFs have built an established position in the product options on offer to European investors. The strength of their presence invokes fear in some, and concern amongst many in the fund industry that have grown up in a world where active managers ruled the asset management world.

But ETFs represent just one part of a much wider shift into low-cost products. They are putting pricing pressure on parts of the active segment and those not willing or able to enter the brutally competitive world of ETFs have been forced to more clearly differentiate their low-cost tracker options from their premium actively managed fund menu.

Passive funds now account for 16% of European investment fund assets. This equates to €1.3trn in money terms, of which €590bn or 47% is invested in ETFs as opposed to traditional index trackers. Since 2002, passives have steadily cemented their reputation as a serious alternative to actively managed investments, with Mifid II rules putting even more vigour into their growth engines.

Despite the pace of growth quickening in recent years, Europe remains some way behind the US, where over 30% of industry assets are now invested in passively managed funds. The US experience clearly highlights the direction of travel for Europe and most commentators expect a similar ratio of active to passive being reached on this side of the pond within the next ten years.

But Europe is a capricious creature and although recent years have seen new money chasing passive over active funds, this year the trend has gone into reverse. According to Broadridge data some €350bn of net new money has been invested in actively managed funds compared to €124bn into passives. ETFs and trackers have taken a roughly equal share of this sum. 2017 has been an extremely bullish year so far and when European investors feel bullish they are inclined to chase performance.

In this environment, they see active managers as able to deliver a value that justifies their fees. This is an unusual year that has seen an extraordinary push into funds. Whilst central bank rates remain at all-time lows, consumers are feeling the pinch of inflation building, and they are playing catch-up after many years of interest drought on their deposit accounts.

2017 has disrupted a longer-term trend towards increased exposure to passives that will undoubtedly reassert itself soon. There are multiple secular drivers ready to reinforce the trend. Underpinning them all is regulatory pressure coming from Mifid II. This has already exerted a profound influence on the Netherlands and UK via regulations that pre-dated Mifid.

Aside from banning sales commissions, which has reduced the incentive to push more expensive actively managed products, in the Netherlands the regulators have intimated that they believe the default product for consumers should be a passive fund and this has caused a more extreme leap towards passives than anywhere else in Europe. MackayWilliams data shows Dutch fund selectors to have a passive weighting of over 40% in their client portfolios.

Passive funds, and particularly ETFs, have traditionally been associated with institutional investment in Europe, but this same MackayWilliams data show that third-party selectors have also bought into the concept. This is of great significance to the future of the industry.

Fund selectors are including passive products into their portfolios at an ever-increasing rate. Five years ago 50% of these selectors of third party funds disclosed use of passives but this figure has risen to over 80% now.

The increased propensity to invest passively inevitably equates to greater pressure on fund charges across the board, but there are other consequences, too. Active managers will be forced to prove their value and seek out product areas where they can excel and where passive funds are less able to secure a foothold. Outcome-oriented products, particularly in the Mixed Asset space remains a vital sweet spot for active managers. Here, there has been no competition from passives – yet.

Equities, though, have proved to be the most vulnerable. In the five-year period since 2010, active equity funds have failed to attract any new money on a cumulative basis. In other words, asset growth has been entirely the result of market performance – and yet, even in the equity category, there are areas of opportunity for active managers. Core regional sectors such as Europe and North America have been no-go areas but, when investors are moving into emerging markets or looking for interesting themes, active funds tend to get the attention.

Despite investors’ reversion to active funds this year, there is no doubt that passives will continue their relentless march into Europe. When performance and yield is hard to find, fees become a primary issue. Nonetheless, this recent experience proves that demand for actively managed funds is not dying. The fund industry is in a phase of realignment; active managers can no longer pitch their investment ideas without proving the monetary value of their propositions to their buyers.