Markets analysis: the risk of passive aggression

Economy, Editor's Choice, Finance | Mon 17 Jul | Author – Business & Finance Markets analysis: the risk of passive aggression

Passive investing does not mean lower risk, writes Aidan Donnelly, Head of Equities, Davy.

Probably one of the largest debates in the investment world for many years has centred on the merits of passive over active investment approaches. More recently the move from active investing to passive has become an increasingly hot topic, with fund flows showing that investors are voting with their feet.

The news media has been all over the story as well, with countless articles in The Wall Street Journal and Bloomberg.

At its most simple, passive investing typically involves an investor buying what is called an Exchange-Traded Fund or ETF. These funds are designed to track a stock market index and as such there is no professional manager actively selecting the holdings in the fund. There are many reasons for ETFs’ booming popularity but these generally come down to their lower fees, transparency, liquidity and tax efficiency.

That said, much of the debate between active and passive strategies boils down to the issue of charges. Is it worth paying the higher costs levied by fund managers and their teams of analysts? Or are you more likely to enjoy greater rewards in the long run by sticking to cheaper exchange-traded funds?

Crucially, most passive funds are operated automatically rather than by a fund manager, dramatically reducing their running costs. And while passive investing looks good when the whole market is going up as it has for eight years, a variety of economic factors and investor sentiment could bring the party to an end – and at that point it could pay to have a human sitting in the hot seat rather than a computer.

CAN’T BEAT, WON’T BEAT

But supporters of passive investing argue that this is missing the point. They point to research showing that most active fund managers fail to beat the market over the longer term. And trying to pick the ones that will is extremely difficult. A manager’s past performance is not necessarily an indication of his or her future performance.

The debate is made all the more contentious as some would argue that the majority of active managers are really pseudo-index followers or ‘closet indexers’, and therefore can never expect to outperform their benchmark index when their higher fees are taken into account.

Cynics would suggest that hugging the benchmark is a form of job preservation. By guaranteeing that a fund won’t deviate too far from the market the manager gets to keep their job, even with mediocre performance. 

One fact that must be borne in mind, though, is that passive investing does not mean lower-risk investing – a mistake that many novice investors can make, particularly after any long period of positive returns. It is incredibly important to understand that investing in equities, whatever form it takes, is risky and therefore any ETF tracking a stock market index will carry the same risk as that index.

IT’S SYSTEMATIC

Although focused on the US investment market, figures from the Investment Company Institute (ICI) give some insight into the scale of migration from active to passive funds.

Since the beginning of 2016, US equity mutual funds – traditionally viewed as active forms of investment – have seen money outflows in excess of US$286bn, while at the same time exchange-traded funds have seen inflows of over US$315bn.

But the proliferation of exchange-traded funds and the significant amounts of money being invested in them, particularly by retail investors, is causing many in the investment world to worry that the seeds of the next big systemic risk have already been sown – and we could reap this harvest sooner rather than later.

Chief among these concerns is the idea that markets could see more periods of one-way momentum coupled, ultimately, with deeper corrections. When things are going well, we would see longer uptrends to the extent that there is more herding in investors’ behaviour.

Is it worth paying the higher costs levied by fund managers and their teams of analysts?

This is reinforced as the shift towards passive funds tends to intensify following periods of strong market performance as money is redeemed from underperforming active managers and channelled to passive funds. In turn, this shift feeds the market uptrend, creating more protracted periods of low volatility and momentum.

When markets eventually reverse, the correction becomes deeper and volatility rises as money flows away from passive funds back towards active managers who tend to outperform in periods of weak market performance.

This situation is further exacerbated by the fact that end investors, in particular retail investors, are becoming more important in driving markets.

Swings in retail investor sentiment, which are often abrupt due to typically shorter investment horizons than institutional investors, are transmitted into markets more quickly as the cushion from active managers accommodating retail investor flows is removed.

aidan donnelly

Aidan Donnelly

ARE YOU FOR (BRAZILIAN) REAL?

We recently saw a good example of this in, of all places, the Brazilian stock market. Following news reports that centred on the alleged approval of hush money payments by Brazilian President Temer to silence a former coalition ally, investors voted with their feet with the main equity index – the Bovespa – closing down 8.8% on the day.

But the price of the iShares Brazil exchange-traded fund shed nearly twice that amount, finishing the day down 16.3%. 

Most active fund managers fail to beat the market over the longer term. And trying to pick the ones that will is extremely difficult

Traditionally, if retail investors suddenly turned bearish and decide to withdraw their money invested active funds from the market, active managers could accommodate this selling pressure by running down their cash balances. In this way, the bearishness of retail investors was dampened.

Nowadays, when retail investors withdraw their money from passive funds that hold no cash balances the fund must sell shares immediately to meet the outflows – and the full impact of the sentiment change is felt in the market.

Longer-term, there are other potential downsides to the shift to passive investments such as a reduction in corporate activism.

The conventional wisdom is that passive owners will show little interest in corporate governance relative to active managers, and as a result corporate activism would naturally decline – and with it the stick to keep company managements in line.

As is often said in markets, the trend is your friend and for now the shift to passive investing seems to be an unstoppable train. Time will tell if the doomsayers are proven right, and investors reap what they have sown.