PassiveMar 27 2019

Breaking from the passive herd

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Breaking from the passive herd

There is no evidence to show that Mark Twain ever said this, but the wisdom behind the quote remains: false confidence is dangerous, and we should always question popular assumptions and preconceptions.

One issue of serious concern is the increasing reliance on algorithms to populate investment portfolios.

It is estimated that by 2021, $1.6tn (£1.2tn) of European investor cash will be invested in computer-driven exchange traded funds. In the US the figure is set to reach $5.9tn.

Reliance on automated investing may, however, be reaching a dangerous level.

Passive strategies may now represent as much as 40 per cent of the US market. In the past decade, $1.3tn of money has been taken out of active US mutual funds, and $1.6tn has been invested in passive funds.

Research indicates that in the UK passive strategies are now responsible for around 50 per cent of inflows, which means the passive share ofthe market is growing rapidly here too.

Good reasons to hold passives

We all know why these strategies have taken off: they are not only cheaper, but have performed better than many actively managed funds, particularly in markets like the US.

We use them ourselves where and when appropriate. For example, while we invest directly in company shares, we sometimes use ETFs to add diversification – they can offer broader exposure across a market and can be traded cheaply and quickly.

Reliance on automated investing may, however, be reaching a dangerous level.

A subset of ETFs focuses only on shares that meet criteria such as high yield or growth companies. These ‘smart beta’ funds attracted $77.6bn last year – up 12.4 per cent on the $69.1bn recorded in 2017. Nearly 500 new smart beta ETFs were launched by 145 managers last year.

Herd mentality

If an ETF is programmed to buy shares that, say, have positive momentum, then it could be forced to buy shares that a rational investment manager can see are heading into bubble territory.

If lots of money is following this momentum strategy it will amplify the trend, driving certain shares (like the so-called Faangs – Facebook, Amazon, Apple, Netflix and Google) ever upwards.

On the back of this, these big companies become even bigger, forcing simple passive fund strategies to buy more and more, building the momentum further into a positive feedback loop.

Many active managers can find themselves under pressure to be part of this, because deciding to ignore a share that is rising can seriously impair your relative performance.

In effect, the market is being mechanically herded and distorted. And then something happens – a profit warning or a regulator intervention – to reverse the trend. At this point computers become forced sellers. Falling markets trigger more sell signals. There is suddenly an about-turn and a dramatic fall in the share price.

What has been disproportionately bought will have to be disproportionately sold – assuming buyers can be found.

Markets always overshoot – and therein lies great opportunity for the smart investor. But the next bear market could see the tendency to overshoot become more extreme than ever, leaving investors in these smart beta strategies particularly hurt because their portfolios cannot adjust quickly enough.

Arguably, the domination of the Faang stocks makes this scenario more likely. The five Faang stocks combined have a market value of more than $2.8tn – more than the GDP of the UK and more than 10 per cent of the S&P 500. Moves in these stocks can cause more than ripples through the wider market.

We have not had much serious volatility since 2008, and algorithmic trading has only really taken root since then – so it has not been tested. In October – Red October, as it was known –we saw the S&P 500 lose 7 per cent in a month and the volatility continued through the rest of the year.

This may be just a small foretaste of what could happen in a bear market. It could also be a sign that normal market corrections are becoming more violent than we have become used to. This presents a serious challenge to the whole industry.

For us it means ensuring that the stocks we hold for clients represent fair value. A rising tide floats many boats, and there are now many stocks on valuations that are difficult to justify.

In a violent market correction everything will be hit, but one would expect robust, fairly valued firms to recover their valuations more quickly.

It also means looking at good but expensive stocks we do not hold and establishing clear target prices, so that if opportunities arise we are in a position to take advantage.

The adviser challenge

Many investors can hold quite substantial assets outside a self-invested personal pension or Isa wrapper that they are reluctant to sell because they will trigger a capital gains tax event. Advisers may wish to review these and, if there are concerns about the valuations, recommend a strategy for disposing of or reducing these holdings.

There is no guarantee that CGT rates will stay as low as they are, and that is another good reason to hold this review.

Key Points

  • Passive strategies have taken off in the UK
  • Normal market corrections are becoming more violent than we are used to
  • Advisers should review stocks held outside wrappers

We believe all investment managers and advisers should discuss and evaluate the risks posed to their clients by automated strategies, whether client portfolios are invested in active or passive strategies or a blend.

This should include assessing whether clients are too reliant on strategies (like FTSE 100 trackers) that are overexposed to certain stocks and sectors and vulnerable to a particularly savage correction.

Consideration should be given as to whether portfolios are positioned to address the greater general volatility that the growth of automated trading strategies may bring.

Advisers may also wish to discuss with outsourced discretionary managers and external fund managers how they are mitigating the market and portfolio risks posed by automation.

And if you are tempted to ignore all this but want an entertaining evening, then I would suggest watching (or rewatching) The Big Short. It may not offer any CPD accreditation points, but it pays us all to remind ourselves occasionally of the folly of leaving confident assumptions unchallenged.

James Horniman is a partner and portfolio manager at James Hambro & Partners