Passive funds are a critical part of any modern portfolio, and an increasingly dominant feature across global capital markets. During the crisis we’ve noted how the scale of assets now tracking indices, up 6-fold to nearly $6tn since the 2008/09 crisis*, are now influencing the behavior of the markets in which they invest. And now, as we look forward to improving market stability but increasing economic change, we consider how best to use passive funds in our client portfolios.
Recent weeks have been a difficult time for financial markets, but as volatility subsides investors will begin to reappraise the shape and structure of their portfolios and may look at the question of active versus passive funds with fresh eyes. Passive investments have been popular in recent years but sliding markets have shown their biggest weakness - investors are condemned to track the index lower. What questions should investors be asking today?
In recent years, many investors have turned to passive strategies on a scale never seen before. The huge growth in passive investment was one of the defining features of the bull market that persisted for almost a decade, until it was brought abruptly to a halt by the coronavirus outbreak.
As those flows have reversed, it has exposed one of the key difficulties in passive investing. While active asset management uses a human element to “actively” manage a fund or bespoke portfolio, using research and judgement to make decisions on which securities to buy, sell or hold, most passive investments simply track an index, such as the FTSE 100 or the S&P 500. Whilst COVID-19’s market impact has seen differentiation across sectors (with oil, consumer and financials hit hardest), most assets held in passive vehicles remain in country or regional specific funds. Investors in FTSE 100 trackers, for example, may have thought less about the types of global companies to which they were exposed than about generally participating in the growth of the UK economy which for historic reasons the weightings in the index now only poorly represent. As such, they have little option but to stay invested in all the companies within the index, no matter how much distress those companies may be experiencing.
The indiscriminate nature of passive funds, together with a number of other factors discussed in our article here , look to have contributed to an increase in volatility and market dysfunction.
Our new generation of investors have often found themselves faced with a binary option – to be invested in the whole index, or not at all. Many, in the face of sharply falling prices, have decided to exit, further increasing the pressure on markets and creating a vicious downward cycle in recent weeks.
Active managers can, in theory at least, use their judgement to pick what they believe are stronger companies and as such should be better positioned to thrive in this environment. A good active manager should be able to sift through stock markets to find opportunities and adjust portfolios to remove exposure to those areas that will not flourish in a post Coronavirus economy. The sell-off has been largely indiscriminate, but there will be those companies that can survive and even thrive in the longer-term.
However, no investor should be basing their strategy solely on recent crisis weeks. While passive investment may struggle in this type of environment, it would be remiss not to mention its natural advantages, such as lower fees, which help compound growth over time. If we expect investment returns to be lower, as the world economy resets, for a longer period of time then the impact of fees will be even more significant.
At the same time, the advantages of actively management are not just limited to flexibility in difficult markets. It can be easier to target a specific requirement – income, for example.
It is also worth noting that while active managers should be in a position to take advantage of this type of situation, not all have done so. There has been some disappointment surrounding a number of active styles, such as value investing, which have struggled to keep up with a momentum driven market. In addition, too many active funds have pursued tight benchmark tracking strategies and thus the industry as a whole has failed to add enough value through outperformance to justify its higher fee structure. There are some fantastic active managers, but it is important to be selective.
It is clear that neither active or passive is the ‘right’ approach taken in isolation. That said, we think that seeking to avoid big losses is more important than trying to find those rare big winners. In a period of change, a large number of companies and sectors face technological or behavioral disruption. Highly indebted companies or those with poor corporate governance are especially vulnerable. Often these risks are not accurately reflected in share prices. It is possible that passive investing is supporting the share prices of companies whose fundamentals do not support current valuations.
Portfolio balance is a key tool that we use to reduce the risk of permanent loss of capital. Portfolios are tilted to the outcomes we see as the most probable but are always constructed to ensure a spread of exposures that would do well in the event of the unexpected. This diversification can be achieved not only through asset classes but also by different types of investment. As assets have grown, the passive sector has also evolved through offering diversified exposure to newer sectors and themes previously the preserve of the few, albeit usually at costs often more closely aligned with actively managed funds. The judicious use of active and passive funds, together with direct holdings, investment trusts and structured products, can all be used as part of the ingredients for an overall actively managed portfolio.
As such, we see greater merits in a quality actively managed portfolio, particularly during more volatile periods for markets. It is undoubtedly true that there is value in holding passive investments given that their structure can offer exposure to specific sectors or geographies at very low cost. However, these should be viewed as most beneficial when used tactically, as part of the asset allocation of a sensible and well diversified actively managed portfolio. And, when markets are hard to read, investors need to be more selective, rather than broad brush, in their exposure.
*Source: Bloomberg.com, 23 April 2020
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This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.