Thought Leadership

31 May 2017

On its own, passive investing is an incomplete investment solution

By London & Capital

AN IN-DEPTH ANALYSIS OF THE MERITS OF BOTH PASSIVE AND ACTIVE INVESTING

Passive investing has attracted a loyal fan base. While active funds continue to dominate in terms of assets, passive funds are growing quickly – some 4.5x faster than active funds in 2016.

The battle-lines in the debate between active and passive managers are well established. Passive managers argue that they deliver better performance and diversification for a lower fee. Active managers argue that a selective approach is vital to manage downside risk and deliver clients’ risk-adjusted return targets.

BACKGROUND AND DEFINITIONS

Active Management

An active manager attempts to beat market benchmarks by using an investment process and experience to select a portfolio of stocks, bonds or funds they believe will outperform. For example, an active manager focused on US equities may try to outperform the S&P 500. The manager may adjust holdings according to market conditions, asset valuations or the fortune of the individual companies.

Passive Management

A passive strategy simply seeks to replicate the performance of an index, such as the FTSE 100 or S&P 500, with little intervention. The fund will buy stocks in the same weightings as are in the index or buy a representative sample in order to replicate the characteristics and performance of the index.

THE CASE PUT FORWARD FOR PASSIVE INVESTMENT…

For many passive advocates performance is the biggest issue. They argue that in efficient markets it is impossible for active managers to uncover mispriced stocks and beat the market consistently. Furthermore, the market is a zero sum game made up of buyers and sellers, therefore the ‘average’ active manager can never outperform the market because they charge higher fees. They also suggest that while some managers will significantly outperform the index, it is hard to find those that do so with any regularity or consistency. As it is difficult to pick both the ‘winning’ manager and when they are likely to win, investors may do better looking at what they can control i.e. fees, which are notably lower for passive funds.

Diversification has also been put forward as an argument in support of passive investment. After all, passive funds provide exposure to a range of sectors and companies within one vehicle. A FTSE 100 tracker will give an investor exposure to banks, miners, consumer discretionary stocks and other sectors all with one portfolio. As such, they offer a cheap and easy way to own a diversified basket of sectors and companies. The same is said for passive bond investment.

There is a simplicity to passive investing that can be inviting. There is no need to monitor managers or individual stocks and bonds. Investors know that when they look at how much the S&P 500 has risen or fallen that day, that is – largely - what they are getting. This predictability of outcome can be reassuring. Investors get exactly what they knew they were going to get.

HOWEVER…

We believe these arguments in favour of passive investment do not give a complete picture, and some of the assumptions made do not stand up to scrutiny. Not all markets are efficient. A passive approach may make sense in a perfectly ‘efficient’ market, however, most markets are not highly efficient and this is demonstrated on a daily basis. The most efficient markets are only made so by the price discovery of active research and investment managers exploiting valuation anomalies. If passive investment dominated, those efficiencies would melt away. It is true that in recent years the average active equity manager has underperformed against equivalent passive strategies, however, performance of active management is distorted by a number of ‘closet trackers’. These are managers who charge an active fee, but in practice, stick very closely to their benchmark and give index-like performance. Results tend to be weak because they charge higher fees.

Historical analysis suggests there is a cyclicality to active and passive equity returns. Early in the investment cycle, passives have the opportunity to outperform as all stocks recover and performance dispersion across stocks remains low. Additionally, in this recovery, passive performance has benefited from Central Bank quantitative easing. Central Bank asset purchases have provided a strong top-down tail wind, squashing asset market volatility, distorted financial markets and undermined the fundamental analysis that drives stock and bond performance.

Percentage of Funds (Fund Assets) Outperforming S&P 500 on a Five-Year Basis (01/31/1970 - 12/31/2016)

However, later in the cycle, when individual security performance is more dispersed, active strategies tend to fair better. They also tend to perform better during market corrections. As Central Banks start to wind down asset purchase programs, we should expect to see higher levels of volatility and greater benefit from selective investment decisions.

While the average active equity manager may have underperformed in recent years, the same cannot be said of active bond managers. Studies show that across all bond categories over half of active managers have outperformed their passive peers after fees over 1, 3, 5, 7 and 10 years.

Percentage of US managed active funds and ETFs that outperformed their median passive peers after fees.

 

 

In several respects the diversification that passive investments provide is an illusion and a passive index weighting methodology can result in significant stock/ sector concentration. In the S&P for example, the market capitalisation weighting results in the top five largest companies making up over 10% of the index (Apple Inc. alone is 3.65%). The top 20 stocks account for just under 30% of the index, therefore not as diversified as you would think.

In the past, the capitalisation weighted approach has led passive investors into blindly taking dangerous country and sector risks. For example, the allocation to Japan within the MSCI World grew from 17% to 41% between 1982 and 1989, as the Japanese equity market bubble grew and grew. Between 1990, when the bubble burst, and 1992, investors suffered losses of -56% on the Nikkei. The same happened prior to the Dotcom collapse when technology represented 33% of the S&P 500 and before the global financial crisis when financials accounted for 22% of the index.

A similar nonsensical approach is evident in the construction of many bond benchmarks and the passive strategies that mirror them. The market weights are based on the amount of debt an issuer floats, therefore, giving investors the highest exposure to the most indebted entities. More recently, this weighting methodology has translated into many passive strategies having a high exposure to negative yielding government bonds.

THE ADVANTAGES OF ACTIVE INVESTMENT

At London & Capital, our investment process is designed to deliver growth while preserving capital and minimising downside risk. Active asset allocation and active security selection are vital in achieving this goal for our clients.

To our mind, one of the key advantages of an active approach is risk management. Investment management is as much about managing risk as it is delivering returns. Here too, we believe that an active approach has some advantages. A passive approach gives nowhere to hide when markets are falling. Passive funds are forced simply to track the market lower. In contrast, active managers can navigate economic and market conditions to protect investors.

For the past few years, markets have been relatively benign and asset volatility has been kept artificially low by Central Banks, but this may lull investors into neglecting risk. With aggregate valuations in stock and bond markets relatively high and the economic cycle maturing, actively managing risk and being selective will become even more crucial.

Active management is essential for delivering a specific investment style and meeting client risk objectives. We design our strategies in line with client requirements and it is difficult to achieve specific, targeted goals using a passive approach.

In conclusion, passive management can have some appeal, but it is an incomplete investment solution and comes with hidden risks. It introduces considerable bias to a portfolio and condemns investors to unthinkingly track the market higher or lower. We believe that this makes it difficult to manage risk effectively and to deliver specific client investment goals. Investors may feel seduced by recent passive performance, but as the economic cycle matures and asset valuations become elevated, now is the time when active management matters the most.