The growth of passive investment products such as index tracking funds over the past few years has been significant as investors are attracted by low fees and the premise that the majority of active managers will not outperform the market over time. Passive investing, or indexing, involves buying a basket of assets that have been included in an index, such as the FTSE 100 Index or the S&P500, or sectors thereof without having to undertake the research and due diligence associated with an active investment decision as performance will mirror the overall movement of the market.
However, some investors argue that the increase in passively allocated money risks distorting the price discovery process. Active investors look to invest in companies whose shares and bonds look cheap and sell those that look expensive, thereby holding management to account by basing decisions on fundamental factors such as earnings growth; competitive prospects and management performance. Price agnostic or passive investors reduce the proportion of share price movements that are based on fundamentals, creating serious market anomalies by being obliged to buy already over weighted and overpriced assets.
This situation is more serious in the less liquid markets of corporate and high yield bonds where passive funds offer total liquidity in an index such as the Citi World Government Bond Index where the level of liquidity of the underlying index components may not compare. Furthermore, the more indebted a company, the more bonds it is likely to have issued, the greater its weight in the index meaning that a passive bond fund will effectively hold a high weighting of bonds in the less credit worthy members of the market place.
The use of passive products in less diverse markets could further contribute to overvaluation and provide a destabilising effect. For example buying sector specific exchange traded funds (ETF) such as the technology sector where market capitalisation may be skewed to a small number of very large companies that would risk breaking some basic investment rules regarding insufficient diversification and exposure to large individual holdings. The performance of the technology sector since Trump’s presidential win has seen Facebook, Apple, Google, Microsoft, and Amazon become over 40% of the Nasdaq 100 Index, which would be in breach of European fund rules if an active manager was to follow the same asset allocation.
Modern portfolio theory would argue that the primary driver of portfolio returns is asset allocation, which is the process of combining various asset groups with different risk and return characteristics (e.g. equities, bonds, cash, private equity, hedge funds, real estate) into one portfolio that will produce optimal, risk adjusted returns. An active investor believes he can outperform a set benchmark by using his skills in market timing, stock selection or style tilt. Smart-beta strategies are semi-active products that reweight on a regular basis in order to maintain an allocation that historical back testing would suggest has been the optimal mix over time. This blurs the boundaries between active and passive by offering the investor one asset allocation remedy based on past performance that any standard market disclaimer would state may not guarantee future success.
There has been a long debate over the relative merits of active and passive approaches to investment when both approaches probably deserve a place in a diversified portfolio. Recent opinion concludes that the ability of active management to generate alpha is probably cyclical; underperforming when returns are overly concentrated or highly correlated such as times when interest rates are low, and, outperforming as economic growth improves, interest rates normalise and market inefficiencies increase. Active managers also have the benefit of making the decision not to be fully invested by holding cash in difficult times which should provide significant downside protection.
Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.
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