Acting in a charity’s best interests: taking a closer look at the active vs passive debate
Ahead of this recent crisis, passive strategies had been finding increasing favour. Attracted by strong returns from key indices such as the S&P 500 amid a lengthy bull market, investors channelled funds towards cheap and convenient index options. However, we believe investors need to tread carefully in today’s environment.
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.
The case for passive investment
In a lower 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 the start of the COVID-19 pandemic. 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.
Bull markets – a passive investor’s advantage
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. This is particularly noticeable in US markets where the FAAMG stocks - Apple, Microsoft, Amazon, Google and Facebook - have seen their prices rise significantly. The sector now (November 2020) makes up around 27% of the S&P 500 index. As prices have risen, investors have chased that performance, creating a virtuous circle.
Why this might not last
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.
The pandemic has seen investors focus on a limited range of ‘beneficiary’ stocks, which has pushed valuations for some of the largest index constituents to even higher levels. As such, it is becoming increasingly difficult for their earnings to keep pace with their share prices. It also means some indices are becoming 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.
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 and the pandemic is likely to accelerate a number of structural changes. Highly indebted companies, those with poor corporate governance or with unsustainable business models appear especially vulnerable. We see many businesses facing material threats even though their shares are still trading on very high multiples.
Often these risks are not being 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 high quality companies operating in profitable and growing industries, we can exclude high-risk businesses that would be impossible to avoid when investing through 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, 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.
We believe that there is value to be found 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 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.
Investment does involve risk. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance. Rates of tax are those prevailing at the time and are subject to change without notice. Clients should always seek appropriate advice from their financial adviser before committing funds for investment. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
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Smith & Williamson Investment Management LLP is part of the Tilney Smith & Williamson group.
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