"Investors should be aware of any lack of transparency in a product, and ensure they remain diversified at the portfolio level. Investors should always review the ETF’s prospectus and ask the provider any questions they have before investing.”
It is also worth considering the potential that passive strategies can bring to an overall portfolio, given the flexibility of the investment product. While traditional passive funds have simply tracked an index, with all the underlying concerns this has for market cap concentration and sector risk, things have changed over recent years.
Clients who want an ESG overlay or want to invest in less liquid or more esoteric investments, such as infrastructure or cryptocurrencies, can now potentially do so by using ETFs.
Product manufacturers can work with index providers or active managers to create versions of an index or basket of stocks that play to a certain theme (such as climate change) or can replicate the performance of an underlying asset (such as crypto) by using synthetics.
That said, Tomaszewski says the popularity of passive investment vehicles is "rather cyclical", so although creating a passive-based portfolio can work in some economic cycles, it might not work in others.
He explains: "From 2012 to 2020 global stock markets generally trended upwards, particularly developed markets. The recovery following the banking liquidity crisis and the presence of world leaders who correlated stock market valuations as an indication of a thriving economy and their ‘reign’ saw the popularity of passive investments increase significantly.
"When stock markets generally trend upwards, it would seem that the overarching ‘common’ consensus is to question paying fund managers to target capital growth while cheaper passive investments are achieving very similar outcomes."
Developments lead to broader diversification
Such developments can help investors match their money with their morals as well as providing the low-cost diversification they need to spread the risk.
But Tilney's Seager-Scott says while there can be plenty of diversification and transparency with passive funds, advisers will still need to help clients manage their investment portfolios.
He cautions: "It's worth remembering that in a multi-asset portfolio you will generally have quite a spread of passives. If you’re using broad market passive funds, this generally means you will have a great deal of diversification at the stock level and a pretty reasonable spread of sectors and geographies."
This comes with responsibilities, though. "One element to remember with passive investing, though, is that it puts greater onus on you as the investor or portfolio manager to fully understand what your exposures are.
