The Passive DFM Conundrum

October 24, 2014


Here is an interesting fact. There are now 163 discretionary fund manager (DFM) propositions in the UK, with a combined £243.8 (€309.2) billion of assets under management, according to the October newsletter from research house Defaqto.

That’s an awful lot of choice isn’t it?

But if you want to use ETFs in your portfolio, then the big DFM names – Brooks Macdonald, Smith & Williamson, Close Brothers, Brewin Dolphin – are not the places to call on. In fact, most DFMs are active fund houses and only use ETFs to make tactical decisions or to take a strong view on a certain sector, say, pharmaceuticals or financials, and do not tend to hold them for the long term.

Bearing in mind the rather narrow wading pool for passive-oriented DFMs, interviewed around 20 UK-based managers over the past year on their investment philosophy, asset allocation, due diligence process and returns.

We found that those DFMs that are focused on, or build their portfolios around, ETF and passives - like 7IM, EBIP and Assetfirst - were confident and enthusiastic about the benefits of passive funds.

Amongst the others, which I don’t particularly want to name, the attitude seems somewhat lethargic.

We all know who I am talking about. It’s the popular active fund houses who decided somewhere along the line that, due to client demand, they would effectively bolt on a passive model portfolio – a second option if you like – and use the same asset allocation with both.

The pitch sounds good. Hand me the new, shiny marketing material.

But it turns out that what can be dressed up as a cheap and efficient response to client demand at launch can end up one or two years later as a shoddy, second-hand offering to clients, still struggling around the £10 million asset mark and pretty much forgotten about. The managers themselves are more used to visiting and interviewing analysts and fellow active managers than analysing tracking error or index replication method.

This lethargy comes across from my interviewees. I’ve incorporated two of my favourite comments collected during interviews from managers of passive portfolios:

“With active portfolios, the skill is where the analysts are out meeting fund managers and the whole review process and feedback from that. We can’t do that part of the process with passive fund managers.”

“Active management is generally superior to passive investing.”

I’ve even interviewed a structured product provider that decided to offer a range of low volatility passive funds, which cost well above the market average and were stuffed full of derivatives. In my opinion, it seemed to be a clever marketing tool rather than a wise investment.

All this makes me wonder; Are active DFM’s use of passive portfolios just a bad experiment? A knee-jerk reaction, if you will, to the fashionable passive fund, and a quick response to the RDR and the so-called “orphaned” clients who can no longer afford to pay for advice?

I can’t give a definitive answer on that.

What I do know, though, is that a passive fund may only be designed to track its index, but it is not a faceless entity. Choosing a product, once your asset allocation is in place, should require as much due diligence and structured thought process as when picking an active fund. What index does it track? How concentrated is the index? What is the spread, the tracking difference, the tracking error? What are the trading volumes?

These are just some of the many questions to which I didn’t always get many answers.

Ultimately, upwards-grinding equity markets have helped active houses to produce returns for clients from passive portfolios by picking the cheapest products from the well-known brands like Vanguard and Legal & General, and they feel safe from scrutiny.

This may not be the case for much longer if global growth heads south and capital markets follow. The emphasis on picking the right products will be far greater, and the scrutiny of the underlying index and the ETF issuer will have to step up. DFMs, and advisers, will also have to shake the attitude that passive funds are the default option for poorer clients.

Perhaps people need reminding, almost two years after the RDR: a passive portfolio does not mean we have to be passive about investing.


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