Why retail investors should not put all their faith in a passive path to prosperity

Investors should challenge managers to offer a range of instruments to help them navigate and capitalise on volatility, argues Saxo Bank’s UK chairman Charlie White-Thomson.

We don’t need no education We don’t need no thought control No dark sarcasm in the classroom Teacher, leave them kids alone 

Pink Floyd, Another Brick In The Wall

Wealth management firms that may have taken these lyrics to heart and believe that retail investors will continue to pay for mediocre service amid continued market volatility and remain fully invested are in for a rude awakening. Their buy and hold approach, which many wealth managers rely on to maximise their fee income, is at best unsuited to these choppy markets and at worst it is not acting in the best interest of their clients.

To paraphrase Pink Floyd, retail investors need education, they need to have greater control of part or all of their portfolio, sarcasm in a healthy dose is a good thing, and the “teachers” or wealth mangers have a role to play in providing guidance and a full set of tools that allow investors to generate returns.

The advice given to the UK retail investors over the past decade has been straightforward and well marketed - be fully invested, stay confident and keep buying, especially when there is a dip or a correction. Backed by low interest rates and supportive monetary policy, many have taken this advice and remained fully invested, to varying degrees of success.

The wealth and asset management industry has enjoyed strong growth in assets under management that has supported their respective share prices. Scale has been important for these firms and innovation has been volume based, including successfully migrating part of the retail investor focus to the index trackers and ETFs away from the actively managed funds.

While the “stay fully invested” mantra in low-cost ETFs and other passive and quasi-passive instruments may have worked well in rising markets, in volatile markets the imperative is on diversification and the proactive management of risk.

A passive approach to investing can breed complacency and wealth and asset managers have missed a significant opportunity to educate and offer their clients diversification. They should have embraced the fact that portfolios have many gears, including the ability to make money when the market declines by going short; capital preservation, including stop losses; hedging of larger positions; vanilla derivatives; a balance between active and tracker funds; use of technical analysis to help timing; and the power of leverage and financial instruments including CFDs.

Notwithstanding the shock from the pandemic, the recent sell-off in equity markets came on the heels of a confluence of factors that predate the pandemic, including stretched valuations, an over-reliance on passive or quasi-passive strategies, and should serve as a lesson for wealth and asset managers as well as retail investors.

Faced with losses or meagre returns, the question that wealth managers and retail investors alike should be asking today is: how can they build resilience and flexibility in their client portfolios moving forwards?

Building a platform that offers the retail investor the ability to buy and sell financial instruments in all their forms takes patience, effort and a strong technology skillset. Not everyone will be able to do it or will want to, which is why we should expect to see some M&A in the wealth and investment management space along the way.

From a regulatory perspective, the traditional buy and hold market provided by wealth and asset management firms may be simpler to regulate, but is unlikely to serve the retail investor well. With this in mind, regulators will also need to be satisfied that retail investors will be equipped to deal with a broader range of instruments. Suitability checks will need to be an important part of the process to achieve this.

The biggest change, however, will need to come from retail investors themselves. The crisis offers an opportunity for investors to challenge their wealth managers into making this shift. They should understand what restrictions are in place that stop them from having access to the range of instruments which would greatly help to diversify their portfolio and therefore introduce resilience in their performance.

Examples of restrictions coupled with mediocre service include: poor access to funds or instruments that offer downside protection; an inability to buy cash-only ISAs, single stocks, bonds and other instruments in the US, China and rest of the world; opaque data and reporting, including no capital gains reports; and, last but not least, mixed loyalties, or being slow to remove high-profile underperforming fund managers from their platforms.

The impact of excessive fees on performance and capital appreciation should be explored in detail. This is not to say that the recent race to the bottom on fees should be applauded either. Firms that do not charge appropriately for their services cannot build first-rate platforms and deliver an excellent investor experience. Fees should be competitive and offer value, with a choice of services linked to fees provided where possible.

The next decade will offer the prepared and educated investor many opportunities to make significant returns. Their choice of wealth and investment manager will have an important bearing on this. The crisis offers retail investors an opportunity to ask questions on whether they are being given access to all the instruments and tools that would allow them to make better investment decisions and generate returns.

Wealth managers who have been counting on collecting fees to passively invest their clients’ money in equities and passive or quasi-passive instruments will soon find that the era of inertia is over - smart investors will begin to vote with their money and search for pastures new.

To quote from another Pink Floyd song:

Money, it’s a gasGrab that cash with both hands and make a stash.

Charlie White-Thomson is chairman of Saxo Bank in the UK.