The endless war between passive and active management has raged for over a decade, with active equity managers consistently ceding ground to their passive peers over the last 10 years; a trend that has accelerated since 2012. The same has been true for bond funds, although perhaps less severely (so far) with 25% of the bond market consisting of passive options; a figure reflected in the high yield bond space.
Percentage of Assets in Passive Equity Funds*
*Data to beginning of each year.
With momentum well and truly behind passive products, investors have been facing increasing pressure to “pick a side”; a binary decision that we feel is more harmful than helpful. Passives aren’t inherently better or worse than active managers (and vice versa). Without meaning to sound trite, they are what they are and, much like active funds, indices have their own strengths, weaknesses and biases that investors should be, but are perhaps not, aware of.
We are agnostic when it comes to passive vs active investing and choose to use passive funds as part of our European, Emerging Market and Asian allocation; areas where we feel a more broad-based exposure to equities can be beneficial to overall portfolio returns. However, there are some geographies where we avoid using passive products, and these are the areas that many investors are being pressured into, namely global and US equities. Though if circumstances were to change, we would not be against holding them.
So, what are the assumptions you need to be comfortable with if you choose to invest into these indices?
Assumption: Fully diversified global allocation.
Global equity passives are often sold as a broad-based exposure to the global equity market however, in reality, they are perhaps less diversified then you would expect. The MSCI World, which is one such global index, has over 1,600 constituents across multiple sectors and multiple geographies which, on the face of it, looks extremely diversified.
The reality is quite different with almost 62% of the index consisting of US equities and the top 10 stocks accounting for over 12% of total stocks. Breaking that down even further, the tech giants (including Amazon) account for 9% of those top 10 stocks. As you can see, a significant amount of geographical, stock specific and sector risk, and these risks are often compounded by introducing a passive US equity fund.
Assumption: US outperforms all other geographies.
If you are buying into global equity passives or supplementing your existing global equity passive with a US equity passive, then you are taking a very large geographical bet on the US stock market. This is one of the reasons you see many passive multi-asset ranges outperforming when the US does well (see 2018) and serially underperforming if the US markets lag other geographies (see 2017).
Assumption: Expensive stocks get more expensive.
Passive indices are often sized by market cap and, as such, the biggest companies make up the largest position sizes in the index; essentially, the most successful companies and geographies dominate the index.
The risk here is that you are, inherently, buying into the most expensive stocks and geographies. From a global equity context this means you are buying into US equities – which look to us to be very expensive relative to history – and US technology, which saw significant drawdowns in Q4 of last year, yet continue to trade at high multiples.
Assumption: Markets only see inflows – the ETF/ QE effect.
Record levels of inflows into ETFs and other passive products have undoubtedly boosted stock markets and, in particular, the prices of the largest stocks in the global/US index. However, it is important to note that, boosted by central bank stimulus which have also led to eye watering levels of share buybacks, we have had one of the longest bull markets in history. We have yet to see the effects of investor monies leaving ETFs and passives en masse, but it would seem sensible to assume that those stocks and areas that benefited the most over recent years, could stand to lose the most should the situation reverse. That being said, the current situation could continue for some time or even accelerate through further unconventional (untested and possibly crazy) modern monetary policy – e.g. helicopter money.
Assumption: All passives are created equally.
Outside of global and US equities, we do see a place for passive funds. In Asia and Europe, areas that are likely to make up less of your portfolio, the opportunity for actual diversification is harder to come by and, therefore, cheaper exposure to a range of equities can be a significant benefit from a diversification standpoint. Additionally, because these areas are seen to have their own issues, they have suffered less from some of the issues discussed above.
Just another tool in the toolbox
On balance, we are pleased to see passives making up a larger portion of the investing landscape. They have increased pricing pressure on active managers and forced many of the larger fund management groups to reduce product fees – a positive for everybody. Additionally, the proliferation and accessibility of passive products gives us, as multi asset managers, more tools to work with which is undoubtedly a good thing for us and for investors.
However, passives are just that, another tool in the toolbox and investing is unlikely to ever be a one-size-fits-all solution for very long. Passives, just by way of construction, are heavily influenced by momentum and momentum has been one directional for several years. Therefore, we remain cautious on the most popular indices, preferring to take advantage of cheap index exposure in areas which look to us to be of better value.