Passive investments come under pressure from regulators

Investors are allocating ever greater sums to passive investments including ETFs and index trackers. Regulators have taken note, says David Stevenson.

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Most active managers underperform the market

Passive investments are on a roll. In the US both exchange-traded funds (ETFs) and passively managed funds have recorded massive inflows. Both products share the same idea: keep costs low and eliminate the risk of an active fund manager underperforming a benchmark index by just buying the stocks inside an index.

The 20 American index funds with the largest net inflows over the past three years raked in a combined $626bn. Those funds, nearly all of which are ETFs, hold a combined $1.4trn. One key factor driving this has been lower costs.

Passive investment costs have fallen fast

The advent of fee-free ETFs is pushing overall investment costs ever lower. US giant Fidelity and US-based fintech firm SoFi both recently brought out a 0%-fee ETF. But cost isn't everything. Demand for passive funds is being driven by poor returns from their competitors. Around 40% of active managers are outperforming their benchmarks on a three-year basis so far in 2019, an improvement on 2018's 30% but down on the long-term average of 45%. American index research firm S&P Dow Jones keeps a close eye on active versus passive fund managers with a regular survey in the US called SPIVA. It says that in 2018 68.83% of domestic equity funds underperformed the S&P Composite 1500.

Over ten or 15 years, 80% or more of active managers across all categories underperformed their respective benchmarks.No wonder passive investing is so popular. In my opinion the US passive funds are likely to eclipse active ones and reach 75% market share in ten years. In Europe it may take longer.

The powerful Big Three of passive investments

No wonder the US Securities and Exchange Commission (SEC) recently launched an "outreach initiative" to investigate this issue. It isn't simply a question of three big players dominating one sector.

I wouldn't be surprised to see them focus on how many big stocks now share the same shareholders on their registers. A few years ago it emerged that Apple, JP Morgan Chase and Citigroup's major three shareholders were the Big Three passive fund managers; this is the case for many other US companies. A 2014 study, entitled Anticompetitive Effects Of Common Ownership, looked into the effects of competing firms having the same asset managers as major shareholders.

It highlighted concerns "that partial common ownership of natural competitors by overlapping sets of investors can reduce firms' incentives to compete: the benefits to one firm of competing aggressively for example, gains in market share come at the expense of firms that are part of the same investors' portfolio, reducing total portfolio value." The upshot, Harvard Law's Einer Huage told ETF Insight, is that the Big Three's dominance "could lead to antitrust liability."

The big asset managers, especially Vanguard and BlackRock, are beginning to wake up to the danger and promising a much more activist approach to governance. I have my doubts though whether this will amount to much.

My guess is that regulators won't be fooled by talk about greater interest in, say, more active proxy voting to keep boards in check. They'll smell a de facto scale-based oligopoly and keep interfering, slowly eroding the dominance of the big players.

Adventurous new ETFs launch in Britain

This growing demand is percolating through to the major ETF issuers, who are getting more adventurous with their new ideas. Over the last few months we've seen several interesting new products launched. Here are the ones that have caught my eye:

Lyxor US Curve Steepening 2-10 UCITS ETF (LSE: STPU): a first-of-its-kind European ETF that delivers positive returns when two-year US Treasury yields steepen against ten-year yields. This is potentially a great product for investors who believe the yield curve will invert and keep on inverting.

Lyxor MSCI Emerging Markets ex China UCITS ETF (LSE: EMXC): the first First ETF in Europe that offers investors exposure to emerging markets without China. A play for investors concerned about the escalating trade war between the US and China but still keen on one of the world's fastest-growing economies.

The WisdomTree Cloud Computing UCITS ETF (LSE: WCLD): an ETF that offers exposure to US-listed companies focused on cloud computing technology. It sits nicely alongside the existing Han-Gins ETF Cloud Technology ETF (LSE: SKPY), which has returned 61% over the last year and 27% over the last six months.

The UBS ETF EURO STOXX 50 ESG UCITS ETF (LSE: E50ESG): for the first time ever investors can gain exposure to a well known index with an Environmantal and Social Governance (ESG) tilt something for the ethical millennials and ESG segment of the market.

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