Why investors are retreating to passive funds as markets fall

Passive funds are destined to follow markets lower – so why have they never been more popular? Sam Benstead investigates.

Choppy markets normally play into the hands of active funds. In theory, stock pickers can shift portfolios into companies that are more resilient to recessions or inflation, or take chips off the table entirely and buy shares back at lower prices.

But retail investors have reacted to volatile markets this year by seeking safety in passive funds, which track entire sections of stock markets meaning that they are destined to rise and fall as investor sentiment changes.

Of the 10 most-bought unit trusts on interactive investor so far this year, six out of 10 are passive funds. Just two were passive funds in the same period last year. Four of the five most-bought funds are passive compared with none last year.

In the top 10 list, five Vanguard funds appear: LifeStrategy 100%, 80% and 60% Equity, as well as its US and global indices. Legal & General’s Global Technology Index also features.

The most-popular active funds this year are Fundsmith Equity, Baillie Gifford American, Baillie Gifford Positive Change and Rathbone Global Opportunities.

Alan Miller, chief investment officer of SCM Direct, a wealth manager that invests only in passive funds, said that 2022 had shown the importance of diversification. 

He said: “Many actively managed bond and stock funds have performed very badly compared with those diversified across different sectors, markets and assets.

“We have seen on previous occasions of market fallout that when investors want to invest for the recovery and the market rebound, there tends to be a wave of index fund buying. This cushions them from the chance of investing in those actively managed funds, which whether due to bad luck or bad judgement, fail to participate in the recovery.”

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Alan Smith, chief executive of Capital Asset Management, a wealth manager that also favours the passive approach, is not surprised by the surging popularity of index funds and exchange-traded funds (ETFs).

He said: “Investors in the UK are now very familiar with the active versus passive debate and the importance of keeping costs down. The fall of Neil Woodford and lower returns (in terms of short-term performance) from the likes of Nick Train and Terry Smith are also not doing active managers any favours.”

Smith adds that while the consensus is that active funds perform better than the market when stocks are volatile, this had not been happening.

Researcher S&P Dow Jones Indices found that – when considering risk as well as return – just 15% of large and mid-cap UK stock pickers beat their benchmark over the past 12 months.

Looking at all UK funds in the past 12 months, just 45% of funds beat the UK index. Over 10 years, only 38% did.

Investors in US shares did even worse. S&P found that only 14.5% of fund managers beat their benchmark over the past 12 months and over 10 years just 5.1% did.

However, it found that 75% of UK small-cap funds beat their benchmark over the past 12 months.

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James Pettit, investment director at wealth manager Rathbones, said choosing to go with active or passive funds depended on the investment area.

He said: “In certain regions, it is much harder to find active managers who consistently outperform their passive counterparts, a good example being US stocks. As such, we have historically incorporated passive-oriented strategies when investing in the US.”

However, he adds that the data pointed to active managers performing better in Europe, Asia and emerging markets.

He said: “With economic and political factors potentially changing quickly, this allows flexible active managers to exploit any resultant volatility. Passive funds, on the other hand, do not have the luxury of such freedom.”

The smaller companies’ universe is another corner of the market where he believes active managers can exploit market inefficiencies through fundamental analysis and stock picking.

He concludes: “In a world of high competition and arguably lower returns for longer, it would be foolish to dismiss passive funds altogether, although we believe that skilful truly active managers have the edge over their passive counterparts.”