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Investors plump for passive in 2022 – AJ Bell comments

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In the year when Fundsmith Equity faces its first calendar year of negative returns since launch, AJ Bell notes that the popularity of ETFs suggests some investors are buying the market dips.

Laith Khalaf, head of investment analysis at AJ Bell, says: “In a year when most markets have fallen and long-standing trends have gone into reverse, you might have expected investors to flock to active managers, who exercise discretion over what to buy, rather than simply following the index. But quite the opposite has happened, with our most popular funds list being dominated by tracker funds. Only Terry Smith of Fundsmith and Jeremy Podger of Fidelity are holding the active fort against the passive hordes storming the top 10.

“Clearly there has been a longstanding trend towards passive management, though in 2022 it may also have been accentuated by a generally poor showing from active managers, as detailed in our recently published Manager versus Machine report. Only 27 per cent of active equity managers outperformed a passive alternative in 2022, and while the longer term numbers are more encouraging for active strategies, that sort of performance doesn’t help to put bums on seats.

“The popularity of ETFs also suggests investors may have been acting somewhat tactically and buying the market dips. Because ETFs trade throughout the day, they offer investors a live price they can buy at, whereas funds work on a forward pricing basis, which means markets may have rebounded by the time your fund purchase has produced your purchase price. In the long term one day’s movement won’t make too much difference, but it’s understandable that when volatility is high, investors prefer the immediacy and certainty of ETF pricing. There may well be a silver lining for active managers here, as some investors may well be using ETFs and passive funds as temporary placeholders, buying quick exposure to the market using an index tracker, and returning at a later date to replace it with an active fund after they have bought themselves some thinking time.

“Indeed, it’s notable that DIY investors aren’t throwing out Terry Smith’s baby with the bathwater. Fundsmith Equity is down 13 per cent so far in 2022, on track for its first calendar year fall since launch in 2010, but it has still proved a popular investment across the year. The style winds that have been blowing in the fund’s favour for the last decade have gone into reverse, with high quality growth stocks taking a licking from rising interest rates. But after so many years of exceptional performance, Terry Smith still has plenty of credit in the bank with investors. The same holds true for Scottish Mortgage, which is down 42 per cent year to date (performance data from Morningstar).

“Neither Scottish Mortgage nor Fundsmith have changed their spots, so there’s no real reason for investors to jump ship simply because these funds are enduring a tough patch. But this year’s rotation from growth to value does illustrate why investors should hold a balanced portfolio with a foot in both camps, and just as it was unwise to bet the whole farm on growth last year, it’s imprudent to swing the other way and go Hollywood or bust on value funds now. Growth will have its day again, but no-one knows when that will be, so it’s best to own a blend of growth and value managers in your portfolio.

“Despite the current dominance of passive strategies in open-ended funds, investment trusts remain a hotbed of active management. The investment trust market has been an exclusively active sphere since the Aberdeen (pronounced Aberdeen back then) UK Tracker trust shut up shop in 2017. Passive strategies don’t really fit with a closed-ended structure, because liquidity of the underlying stocks is generally good and ongoing demand for trackers is high, so investment trusts are likely to remain a safe space for active managers to continue to deviate from the market.

“The leaderboard of the most popular shares of the year contains a list of long-standing London Stock Exchange stalwarts, and Tesla. Clearly the likes of Shell and BP have had an exceptional year of performance, and like many of the other stocks in the leaderboard, they provide a healthy dividend yield, which is likely to be a more prized asset if growth falters. It’s interesting that investors haven’t been driven away from Tesla in a year when the stock price has fallen by 60 per cent, which shows they still buy into the long term investment case. The erratic behaviour of the CEO does seem to be at the very least a distraction though, and with Musk now in charge of Twitter on a free speech mission, and a US presidential election on the horizon, the spotlight is unlikely to shift from his more controversial exploits.”

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