Rethinking passive in a changing world

Active asset management uses a human element to ‘actively’ manage a fund’s portfolio, using research and judgement to make decisions on which securities to buy, sell or hold. In contrast, passive investments are low-cost strategies that typically aim to track an index, such as the FTSE 100 or the S&P 500 index.

Passive investments have been used for decades, but in recent years many investors, including charities, have turned to passive strategies on a scale never seen before. This is an important shift, with the choice of active versus passive investment strategies potentially making a significant difference to a charity’s costs and risk profile.

In a lower-than-expected return environment, the low fees involved in passive investing are clearly attractive. Many of these vehicles are very large and therefore benefit from considerable economies of scale. Passives do not incur the usual expenses required for active management and can engage in strategies which can help reduce their cost base. Cost reduction strategies include lending stock to short sellers for a fee or making a profit on the bid-offer spread on their high daily turnover.

Disappointment surrounding active manager performance has further driven investors towards passive vehicles. A number of active styles, notably the ‘value’ approach, struggled to keep pace with the momentum-driven markets that prevailed until 2022. 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.

The strong performance of passives has had specific reasons behind it. It is argued that many of the equity market returns since 2009 have been driven by central bank policy, quantitative easing and low-interest rates and that these factors have overridden other considerations.

With more money in the system, significant fund flows have been directed towards certain indices. The largest stocks in those indices have seen their share prices rise higher as a result. As prices have risen, investors have chased that performance, creating a virtuous circle. This was particularly noticeable in US markets in 2021, where the FAAMG stocks – Facebook (now Meta), Apple, Amazon, Microsoft, Amazon and Google (now Alphabet) - saw their prices rise significantly as investors willingly paid higher and higher prices for the same income stream.

Passives are beginning to have considerable impact on the marginal pricing of stocks, market volatility, cross-correlations and price discovery. There is no strategy or asset class in the world that can’t be ruined by having too much money thrown at it, and a fundamental concern with passives is that they can channel money into areas that have already performed very well and their starting valuations are expensive.

The pandemic saw investors focus on a limited range of ‘beneficiary’ stocks, which pushed valuations for some of the largest index constituents to even higher levels. As such, it became difficult for their earnings to keep pace with their share prices. It also meant some indices became increasingly concentrated in specific sectors, notably technology.

This naturally increases stock-specific risk within a portfolio, an undesirable situation for charities seeking lower volatility and consistent returns. Trustees seeking outperformance over the long term are well advised to select investment managers that can demonstrate respectable performance during market lows, as well as market highs.

With higher inflation, central bank policy has completely reversed. We are seeing tighter monetary policy through quantitative tightening and higher interest rates. This new environment has put the most pressure on the more expensive and most owned areas of the market.

As long-term investors, we see risk as permanent loss of capital rather than volatility. For us, avoiding big losses is more important than picking big winners. We are in a period of unprecedented disruption: popularism, the pandemic, the trade war with China, and the Russian invasion of Ukraine, which are all accelerating a number of structural changes. Highly indebted companies, those with poor corporate governance or with unsustainable business models are especially vulnerable.

Often these risks are not reflected in share prices and it is possible that passive investing is supporting the share prices of companies whose fundamentals do not support current valuations, thus creating price distortions. We believe that by being more selective with our stock selection, focusing on reasonably valued, high-quality companies operating in profitable and growing industries, we can exclude high-risk businesses that would be impossible to avoid when investing through the classic index trackers.

Portfolio balance is the second way that we seek 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 has been important during the pandemic and years following, where the effects have been both unpredictable and far reaching.
When considering an appropriate investment strategy, trustees must ask themselves - does allocating capital according to market capitalisation, while concurrently ignoring valuation measures and business fundamentals, really accord with the fiduciary duty of trustees? This is particularly important today as investors adjust to a changing world. We believe we need to retain the flexibility to invest strategically.

There are now something like three times more passive indices than there are underlying investment securities, so passives cover every conceivable combination of holdings and so are arguably now more about a type of investment execution than any particular type of strategy.

It is undoubtedly true that there is value in holding passive investments given that their structure can offer exposure to specific sectors, geographies and strategies at low cost. However, for most of our clients we think passives are generally most beneficial when used tactically, as part of the asset allocation of a well diversified actively-managed portfolio which we think will be better suited to the type of market we expect to see in the next few years.