Beware hidden pitfalls on passive route

Passives promise low costs and simplicity for investors, an enticing mix in today’s low-return world. However, this does not mean they can be bought with impunity. Investors must have a fundamental understanding of why the strategy works and be aware of the pitfalls that the ignorant can blunder into.

Equity market indices represent the performance of the average share. For every pound that outperforms the index, a pound underperforms – it is impossible for all investors to do better than average. Investment activity is not a zero-cost exercise, especially if expensive active managers are employed. Hence the passive route of investing in the index in a low-cost manner will lead to incremental outperformance of the average investor returns.

 Several smart beta strategies may not be as powerful as the back testing indicates

For too long active managers have received high fees for providing a combination of market return and modest alpha generation. The arrival of passives has stripped away the rationale for using active managers to gain simple beta exposure, leaving stockpickers to focus on generating outperformance.

This is not to suggest that all benchmarks are suitable for passive replication. Some of the more archaic indices such as the Dow Jones Industrial Average or the Nikkei 225 are constructed on a price-weighted basis. Given the underlying philosophy behind the passive approach this could work reasonably well, though many may feel it makes more intuitive sense to determine allocation by business size rather than share price size.

But there are dangers lurking inside traditional market-weighted indices that may catch the unwary. I am sure there are many investors today who have blindly bought into gilt indices without appreciating how the interest rate risk has been transformed by the long bull run in fixed income markets.

The combination of new issues’ lengthier maturity terms and the massive price appreciation of existing, longer-dated bonds have pushed out the overall duration of the index. To obtain a similar level of interest rate risk in portfolios, buyers of the conventional gilt index need to take roughly two-thirds of the allocation that they did 10 years ago. I suspect few advisers are aware of this.

More aggressive passive investors are deliberately targeting non-traditional areas of the market. This may involve taking exposure to less liquid parts of equities or fixed income.

Flows into small-cap index funds have been relatively low, but global high-yield bond indices have attracted a considerable following. If credit markets were to seize up again as they did in 2008, passive funds could suffer a severe liquidity squeeze if hit by heavy redemptions, and this could intensify pressure on prices.

Associated with this problem are the smart beta or factor-investing strategies. Many of these products take mechanical approaches to capture return anomalies, which have been identified from extensive analysis of historical market returns. These products have been designed to operate as pseudo passives to exploit these opportunities.

This sounds highly attractive on the face of it, offering above-average returns and below-average management costs. 

However, Research Affiliates in the US has recently done some excellent work examining the effectiveness of many smart beta factors. Its analysis has uncovered some fascinating conclusions around the way that earlier studies have been distorted by factor-valuation changes. Several smart beta strategies may therefore not be as powerful as the back testing indicates. 

The firm’s work also considers the likely implementation costs and demonstrates that dealing charges can materially eat into the expected outperformance of some of these strategies. Investors need to tread carefully when extrapolating past trends and looking at pro forma track records.

Passive strategies can act as an important tool for portfolio management purposes, but there are many pitfalls that await the unsuspecting investor.

Jason Broomer is head of investment at Square Mile Investment & Consulting