Passives use has gone from being selective to obsessive

Before I explain why, I should first acknowledge that the selective use of cheap passives makes sense. Markets are a zero-sum game and more than 50 per cent of active managers underperform. There is also a lot of cost pressure out there and this is only increasing and leading more investors towards passives. So we regularly advise our clients to use index funds selectively. Why then are we cautious?

We are concerned the use of passives has gone from being selective to almost obsessive, and indiscriminate use can be counterproductive even when cost savings are made. That is because seeking cheap return averages – what index funds are good at delivering – can be a costly idea too. This is particularly relevant when markets are above historic averages and buying index strategies could be a way of averaging down, not up. 

All else being equal, there are two environments that strongly favour active management: When returns expectations are low and when market risk is high.

Index funds are good at managing returns but poor (and even indifferent) at managing riskRory Maguire

Why does a low-return world favour (selective) active management? While we are suspicious of clichés, one we agree with is that we are in a low-return environment. The evidence seems overwhelming. Stockmarkets – powered by an expensive US equity market (particularly in sterling) – are top-heavy in valuation terms. And bond markets, which tell you precisely what to expect in the way of returns – suggest a very low return even for those with a 10-year view.  

This points to a world where prospective returns look limited. For example, a commonly used portfolio such as a moderate-risk strategy may struggle to deliver 3 per cent. If you owned a passively managed strategy within this risk band, these prospects appear very modest. Yet, if you select a proven active manager, alpha can be disproportionately high when returns are low. If they add say 1.3 per cent a year (after fees) to the 3 per cent market average, the alpha becomes 30 per cent of the total return. Alpha can be very powerful and important in a low-return world.

Higher-risk markets also favour active management: Index funds are good at managing returns but poor (and even indifferent) at managing risk, and our sense is that markets look particularly risky. It is quite rare to find so many equity and bond markets looking this expensive relative to history, suggesting market corrections could be close by. Losses may be even more acute for UK investors buying expensive foreign assets with sterling, should these mean revert at the same time.

It is extreme risks like these – which fall outside the averages that power index funds – that active funds can help mitigate. Managers have tools at their disposal – whether it is reducing bond duration, credit exposure, equity exposure or even hedging currency risk. Index funds, by contrast, are takers of the risk employed by the market and this can hurt when markets get fearful.

Clearly the choice between active and passive funds is a very complex one and we do not aim to simplify it here. And we back both when building portfolios.

But our sense is that the use of passives has become such a focus that clients could be exposing themselves to undue risks. Market averages are worth pursuing when markets are behaving in an average fashion – which is most of the time. But, now, it seems we are outside these averages and this is probably time to question how much pure market risk you take.

Rory Maguire is managing director at Fundhouse