Calling the market
The real problem is that we have no historical precedent to measure the implications of the potentially sudden and huge outflows from passive funds that are likely to be triggered by any abrupt downturn in equity markets.
That is not to say that an equity market crash is imminent. Asset managers have learnt to their own detriment that attempts to time the market are frequently futile, with the prediction of highs and lows proving a very inexact science – even with the Buffett metric as a guide.
Indeed, any investor choosing to dispose of their equity holdings in 2012, when the ratio hit 100 per cent, would have missed out on five years of solid gains and a bumper 2017. Furthermore, almost nine years into the current bull market, robust corporate earnings and solid economic momentum constitute compelling reasons for holding on to equities, rather than hiding from them.
In addition, the fear of missing out on a further melt-up in equity prices can exert an overwhelming psychological influence.
So how can investors balance such considerations?
Although ‘buying the market’ has unquestionably proved a lucrative decision in the post-GFC years, this has not always been the case. In fact, historically speaking, the passive versus active dynamic has had a decidedly cyclical feel to it.
According to the data, there is a tendency for active managers to outperform during downturns (2000-02 and 2007-09). This partly reflects the typical case that markets tend to be more fundamentally driven when the emphasis is on capital preservation. What is not quite so obvious, however, is that active managers also tend to outperform during the infancy of bull markets (1982-85, 2003-05 and 2009-11).
The obvious inference we can draw from this is that market momentum, driven by passive inflows, tends to only kick in once a bull market becomes established, while we typically see accelerated outflows and relative underperformance from passive strategies when the tide turns.
Consequently, while we could point to a number of reasons for staying invested in equities, the cyclical interaction between passive and active fund outperformance firmly suggests that the sun is about to set on the former, as we move towards a new dawn for active management.
‘Buy-and-hold’ investors should therefore consider implementing an active tilt to their equity portfolios. However, it is important to choose a manager that seeks to create value for investors through material benchmark differentiation, rather than those who are effectively ‘closet indexers’.
Matt Beesley is head of equities at GAM