Investors seeking to position themselves for the period ahead, may benefit from re-examining the role of passive strategies.
The surge in popularity of passive investment strategies has been one of the most notable developments in markets since the financial crisis. This has led to frequent – and often intense – debate over the merits of active investing. However, as the global economy moves into the next phase, investors may be forced to re-evaluate the use of passive investments – as well as the expected returns.
The strong returns of passive strategies since the financial crisis have been driven by central banks – with ultra-low interest rates, combined with trillions of dollars of quantitative easing, causing valuations to balloon since 2008. Market returns, or beta, have been much higher than excess returns, or alpha, during this period.
However, this era is almost certainly over. Given current valuations, expected returns of equities and bonds are diminishing – or at least much lower than market returns since 2009. When beta return is 10%, an alpha of 2% is nice to have, but not essential. When beta return is 5%, an additional 2% from alpha could be critical. In this environment, investors will face the choice of either accepting lower returns or adopting a different strategy in pursuit of similar returns.
As the impact of QE recedes, cross‑sectional volatility is also likely to return. When markets are flooded with central bank money, most assets are lifted, and selectivity becomes less important. When markets return to more normal conditions, dispersion between sectors and securities is likely to reappear. We are likely to be heading into an environment where active management is not only important, but also has more opportunities to add value.
The wrong side of disruptive change
The perception that passive strategies are lower risk may also need to be reassessed. Many investors believe that passive strategies are a risk‑free way to invest, but this is a mistake. Most equity indexes, for example, are weighted by market cap. This means investing in the index is effectively a bet that the most recently successful companies will continue to be successful.
History shows us that this is not always the case, though. IBM, Philip Morris, Coca‑Cola and General Electric have all been among the largest 10 firms in the S&P 500 Index in the past, but over the 10 years to the end of August 2019, the cumulative returns of these stocks lagged the index by 189%, 112%, 63% and 270%, respectively.
Passive investment strategies can make it more difficult to be on the right side of disruptive change. Kodak, Nokia, Xerox, Blockbuster and Yahoo were all giants, but each failed to identify disruptive forces. A good active manager, with a keen sensitivity to change and disruption, could actively tilt the portfolio, not only to avoid disrupted firms, but also to benefit from the disruptors.
Passive bond strategies are arguably even more vulnerable. The Bloomberg Barclays Global Aggregate Bond Index weights issuers by the amount of debt issued, meaning that any passive strategy will be overweighting the most indebted issuers. While it may not be a problem to have an approximately 40% allocation to US government debt, holding a 16% weighting in Japan is likely to carry more risk, as is an overweight allocation to Italian government bonds.
The return of volatility and dispersion
The global economy is likely to be hit by considerable volatility over the next few years, as the diminishing impact of central bank stimulus removes artificial support from markets. At the same time, the US‑China trade dispute and the rise of populism in various parts of the world are likely to bring added turbulence. Considerable rotation within sectors and asset classes can be expected. In this environment, passive strategies are likely to perform less well than during the long period of relative stability and growth since the financial crisis.
This is neither to suggest that it is “wrong” to invest in passive strategies, nor to suggest passive investments will not have a role to play in the future. Passive strategies will very likely continue to perform an important function in portfolios, albeit in a different way than in the recent past.
It is often suggested, for example, that passive strategies should form the core of a portfolio, with active investments used as “satellite” investments. In the future, the opposite may be the case. The active core is unlikely to be changed too frequently, while the thematic satellite allocations may be swapped on a more regular basis.
These developments will become clearer over the next few years. In the meantime, investors seeking to position themselves for the period ahead may benefit from at least re-examining the role of passive strategies as the impact of central bank stimulus fades – as well as considering how active strategies may be deployed more effectively in the future.
Yoram Lustig is head of multi‑asset solutions EMEA at T. Rowe Price.