The use of passive funds has been increasing for years, with investors drawn to their simplicity and low cost. But are they the right investment for all markets, and what happens if a market dip is on its way?

Passive investments track an index or market, such as the FTSE 100 index of leading UK companies, and will replicate the performance of that market.

It will never outperform the market and will follow it up as well as down. This means if the FTSE 100 rises by 5%, so too will your investment, but likewise if it falls by 5%, your investment pot will fall by the same amount.

Because there is no fund manager running the money and picking stocks, as there is with active funds, passive investments are typically cheaper. What’s more, as passive funds have grown in size they have passed on cost savings to investors. Our recent article showed that the cheapest exchange-traded funds, a form of passive investment, charge just 0.04% – which is 40p for every £1,000 invested.

WHY ARE THEY SO POPULAR?

Investors are flocking to passive investments at the moment. The most recent figures from industry trade body the Investment Association, which tracks where UK investors are putting their money, shows that they allocated £1bn to tracker funds in September.

This is remarkable when the net sales for all funds that month were just £642m (the figures collate inflows and outflows, with other fund types seeing a net outflow).

Tracker funds now represent 15% of the total fund market today, compared to 6% a decade ago, according to the Investment Association data, and there is now £195bn of money invested in them in total.

The latest figures from AJ Bell YouInvest on the most popular funds in October show this trend clearly.

Among the top 15 investments were a healthy dose of passive funds. This was split between pure trackers and passive portfolios that allocate money across a number of different asset types and stocks markets, such as AJ Bell’s own passive funds and Vanguard’s LifeStrategy funds – each of which have a range of different funds with varying allocations to different countries’ stock markets, bonds and cash.

Another large chunk of the most popular funds was in more simple trackers, which just track one market. The most popular markets were the FTSE 100, FTSE 250 and the S&P 500 index in the US.

However, markets have fallen in recent months. In October the FTSE All-Share had its worst month’s performance in more than three years, with the past 10 years only seeing eight months that had greater falls.

What’s more the FTSE 100 was down 5% over September and October, leaving it down 7% in the year so far.

UNAPPRECIATED RISKS WITH PASSIVE INVESTMENTS

If investors fear further market falls – whether due to Brexit, trade wars, the fall in grace of the FAANG technology stocks or some other reason – should they switch to active fund managers?

Jane Sydenham, investment director at wealth manager Rathbones, says: ‘One of the key issues here is that passive funds are really untested in a serious market fall. We are 10 years into a bull market, in which passive investing has exploded in popularity, such that it now dominates daily market activity – that was not really true in 2008.’

Trackers have no ability to outperform the market, and in a declining market that means these investors have no way of limiting their downside. An active fund manager will aim to avoid the worst-performing companies and stop investors’ savings falling as much as the market does in any downturn.

What’s more, they will also be able to buy the dips, and snap up unfairly discounted shares in a market fall. This relies on you picking the right fund manager who makes the right calls in hard markets – no easy feat when many fund managers have been investing in a bull market for the past decade.

Sydenham comments: ‘In theory, it is likely that active funds will perform better as they can hold liquidity and buy more concentrated positions of oversold holdings when they have fallen heavily.

‘In markets that are no longer distorted by quantitative easing, there should also be more dispersion between stronger and weaker stocks, and that should also favour active funds, but the managers of active funds have to still make the right decisions, so investors need to be confident in the ability of the active manager.’

WAYS TO PLAY CHEAP UK MARKETS

One particular area of opportunity is in domestically-focused UK stocks, which have been hit since the referendum vote and during the ongoing Brexit uncertainty, meaning many companies are now sitting on healthy discounts.

Currently FTSE 100 companies are trading on 12.5 times earnings, which is below the historical average, with a dividend yield of 4.5% – above the long-term average.

Investors who think there is opportunity for UK-focused stocks to rebound could consider investment fund Man GLG Undervalued Assets (BFH3NC9). Henry Dixon, who runs this £1.2bn portfolio, aims to hunt out discounted companies that he thinks will rise in value.

Investors looking for downside protection can invest in funds that specifically aim to reduce volatility and protect in a market downturn.

A good example is the £2.5bn Janus Henderson UK Absolute Return (B5KKCX1), a fund run by Benjamin Wallace and Luke Newman. The fund can ‘short’ stocks, so effectively bet against them, and aims to deliver a positive return and to drop less than the FTSE All-Share in a falling market.

Both the Man GLG and Janus Henderson products feature on AJ Bell’s list of favourite funds.

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