InvestmentsMar 18 2021

The passive perspective

Supported by
BMO Global Asset Management
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Supported by
BMO Global Asset Management
The passive perspective
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Central banks' policy of buying bonds as part of quantitative easing programmes pushed bond prices upwards, and kept interest rates low. This also benefited equities generally as it meant the rewards for owning bonds were lessened.

In such a climate, a multi-asset portfolio containing mainstream bonds and the equities of most markets did well, with exposure to those assets from passive instruments delivering returns.

The onset of the pandemic led to a sharp bifurcation in asset price performance, with those stocks perceived to be losing out as a result of the changes wrought by the pandemic falling sharply, while those perceived to be benefiting rose sharply. 

As vaccines rolled out, market participants became more optimistic about the economy, and, at the start of February, began to buy many of the economically sensitive stocks that had fallen farthest, and sell off many of the technology-focused stocks that had performed best. 

Disruption is the friend of the active investor - Sunil Krishnan

Such a volatile climate contrasts with the benign market conditions of the previous decade, and may prove a challenge for passive investment returns, says Kevin Thozet, member of the investment committee at Carmignac.

He says bond investors will find that in the changed economic climate there is an increased chance that some companies will default on their bonds, while some companies which had been reliable income payers pre-pandemic, are structurally challenged and may never return to previous payment levels, which will have long-term consequences for the place of those stocks in passive income portfolios. 

Nick Watson, multi-asset investor at Janus Henderson, says that historically periods of volatility in investment markets are when active funds tend to outperform passive.

Funds in the IA Global sector have underperformed the index for the past decade

Sunil Krishnan, multi-asset fund manager at Aviva Investors, says a feature of the economy during the pandemic has been that many smaller companies have performed well. He says advances in technology also make it easier for smaller companies to grow quickly. 

Krishnan says in such an environment, passive funds which buy the companies in an index based on their size, may struggle as those businesses lose out to smaller companies that are further down the index.

He says: “Disruption is the friend of the active investor, and so we are more interested in active investing now than we were last year, we are now leaning on the active managers more for solutions now.”   

Keith Balmer, multi-asset fund investor at BMO Global Asset Management uses both active and passive strategies in the mandates he runs, but says that an investor whose priority is income will likely need exposure to active funds to achieve the target, particularly as to achieve a decent yield right now may require allocating to emerging market bonds and high yield bonds, both areas where he believes passive investing would struggle to beat active. 

Andrzej Pioch, multi-asset investor at Legal and General Investment Managers says one of the issues he has with passive investing is that it tends to leave clients exposed to a relatively small number of large stocks.

He says 60 per cent of the returns achieved by the US market over the past decade came from just six large technology stocks. As passive funds allocate based on the size of a company in an index, as each of those tech stocks rose in value, so the passive funds bought more.

This means the more those stocks rise, the more of them the passive investor owns, creating a scenario where passive investors' portfolios come to be dominated by a small number of holdings, creating concentration risk. 

Small holdings

Andrew Hardy, director of investment management at Momentum says the farther down the market cap scale an investor goes, the more likely it is that active investors will win. 

Iain Barnes, head of portfolio management at Netwealth, a discretionary fund house says: “We are whole-hearted supporters of the growth of passive strategies, as historic evidence shows how hard it is to pick out the managers who will become the minority of sustained outperformers in forever changing market conditions.

"Our primary aim as an investment team is always to align our portfolio construction with the firm’s overall ethos: delivering quality performance in an efficient way.

"That means usually using passive funds with active asset allocation, but you still have to choose the right funds, and that means selecting the most appropriate indices to track as well.

"An increase in stock performance dispersion should help stock-pickers as a group to showcase their skills, and if we can see a manager who is best-placed to mitigate some of the risks embedded in different market exposures – at the right price - then we don’t rule that out.”

Paul Niven, head of multi-asset at BMO GAM and manager of the firm's MAP fund range, says: “With cost-considerations to the fore the push to passive has been significant.

"Passive strategies have also enjoyed the tailwinds of favourable market conditions – an environment that has led to many questioning whether the additional cost of active management is worth paying.

"We think – at the right price point - it is, for three reasons. First is the scope to outperform – something a passive strategy inherently can’t do. Second, is the ability to protect capital in more challenging markets.

"Passive strategies enjoy the benefits of rising markets but suffer when markets do. An active strategy, however, obviously faces challenges when markets trend downwards but the impact can be limited by active decisions such as reducing market exposures, adjusting asset class and geographic weightings or emphasising more resilient companies.

"The third reason is the potential for harnessing volatility – either to harness returns or protect capital.”

David Thorpe is special projects editor of FTAdviser

david.thorpe@ft.com