Already accounting for more than 14% of the European market, passive funds are set to represent around a quarter by 2025, a recent report by Moody’s Investor Service has estimated. However, could this growing success story be checked by environmental, social and government (ESG) concerns?
“Mifid 2 has been a game changer disrupting the traditional value chain: the impact has been increased transparency and pricing pressure, leading to a new focus on low-cost passives,” said a recent review (PDF) of the Ucits fund market by the Association of the Luxembourg Fund Industry.
These new rules make it clear to investors how much they are paying each year in management fees for their funds. Funds that follow an index rather than being actively managed by research teams tend to cost substantially less, often with similar levels of investment performance.
As well, “the digitalisation of distribution channels will also underpin retail demand for passive investments across Europe,” said Marina Cremonese, senior analyst at Moody’s.
Hence the prediction by the firm that appetite for these products in Europe will increase from 14% at the end of last year to between 22% and 27% by 2025. This prediction is backed by evidence from the US where passive funds are set to account for about half of the market mid-way through the next decade. Luxembourg will feel the pressure, as active managers seek to bear down further on costs being incurred for fund administration and distribution.
Yet could the way index funds’ low cost, non-discriminatory investment strategy be their weakness? A new report from InfluenceMap, a UK non-profit organisation, has shown that some of the largest asset management companies in the world have increased their holdings in coal-related companies by a fifth since 2016. That is, since the Paris climate agreement. The NGO found that much of this was driven by the growing appetite for index funds, many of which automatically invest into the largest companies on a stock market. And often these are in the hydrocarbon-energy business.
This points to another concern that passive funds cannot be activist investors. Increasingly fund managers are using their shareholding clout to nudge businesses to meet environmental, social and governance goals desired by increasing numbers of retail investors. They do this by threatening to disinvest if action isn’t taken. But this option isn’t open to passives. Even if the passive fund is openly geared to ESG, it will by definition have less clout.
Even the man credited with founding the modern index fund industry has expressed his doubts. Jack Bogle, the founder of Vanguard, one of the three big players in the sector, told the Wall Street Journal in November: “if historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large US corporation”. He saw potential downsides in such an over-concentration of power.
Much recent talk in the sector is how funds must be made appealing for a younger generation. While low cost passive funds sold by robo-advisors might suit millennials’ budgets and technophilia, could this appetite be dimmed by worries about how these funds invest and are governed?