With markets taking a dive, should passive investors reconsider?

Passive funds have done well during years of buoyancy, but Tom Bailey asks whether investors need smarter strategies for a more volatile future.

Despite the scare stories that the rise of passive investing imperils markets and capitalism, from an investor perspective exchange-traded funds and index trackers have done exactly what they promised. They have provided solid market returns with ultra-low fees.

According to the latest research from Morningstar, looking at the performance of Europe-domiciled active funds versus their passive peers in their respective Morningstar categories between 2008 and 2018, active managers survived and outperformed passive peers on average in just two of the 49 categories. As might be expected, US large-cap active funds were among the least likely to provide outperformance. But even in so-called ‘under-researched’ markets such as Asia or Latin America, less than 50% of active funds outperformed.

However, the strong performance of index-tracking funds has coincided with one of the longest bull markets on record, with indices from the US’s Dow Jones to the UK’s FTSE 100 breaking multiple records. The question for investors, then, is whether or not passive investment strategies still make sense once market steam runs out – an issue the recent sell-off in markets brought to the fore.

That depends on whether the October rout was just a brief correction – as the market dip in February of 2018 turned out to be – or the start of a broader downward trajectory for markets. A bear market, in other words.

If the former is the case, the sell-off and fall in prices presents an attractive opportunity to ‘buy the dip’, as it is commonly known. As Peter McLean, director at Stonehage Fleming Investment Management, notes: “The practice of ‘buying the dip’ has worked well during the current bull market, with corrections proving to be shallow and shortlived.”

Is the party now over?

This was the route chosen by many investors in October. ETFs tracking some of the hardest-hit sectors, such as the S&P 500’s tech-orientated Communication Services or the US mid-cap index, saw heavy inflows in the last week of October. Eric Balchunas, a Bloomberg Intelligence analyst, noted at the time: “It looks like the trading crowd doing some dip-buying as a result of the recent drop.”

However, what if, as some contend, the October sell-off was a prelude to either more volatile or flatter markets going forward? According to McLean: “As we transition to an era of rising rates, investors should be braced for sharper bouts of volatility that take more time to repair, as central bankers are more tolerant of market weakness.”

Similarly, Jonathan Webster-Smith, head of multi-asset at Brooks Macdonald, argues: “Broadly speaking, we expect more episodes of market volatility as the global monetary policy backdrop shifts from quantitative easing towards quantitative tightening.”

That presents risks for passive vehicles that can only go up and down with markets. A period of sustained falls can do long-term damage to those invested in such tracker funds. Oliver Smith, portfolio manager at IG, says recent research he carried out showed that had an investor placed their money in a MSCI World tracker in March 2001, taking into account inflation it would have taken the investor until March 2014 to see a positive total return. “Markets can be very disappointing over extended periods,” notes Smith.

However, others take the view that investors should just ride out any such volatility or downturn. According to Robin Powell, head of client education at pro-passive investing financial planner RockWealth: “Volatility is part and parcel of investing – it’s what provides the equity premium. Investors need to take the long-term view, ride out that volatility and, crucially, continue to invest.”

Similarly, James Norton, senior investment planner at passive specialist Vanguard, argues: “Successful investing is about having a plan and sticking to it. Investors should think about their long-term goals and not be put off by the increased noise of commentators.” Such concerns are always raised when market volatility increases, he says.

Indeed, attempting to time the market so as not to “buy the peak” also risks long-term portfolio damage, given that the big gains in each bull market often occur in just a few days of trading.

Take the 5,036 days of trading on the S&P 500 between 1998 and 2017. Being fully invested for the whole time would have given an investor an annualised return of 7.2%, according to data from Index Financial Advisers. However, had an investor been out of the market for the five best days of trading over that 20-year period, those annualised returns would have fallen to 5.02%. Missing the best 20 days would have led to annualised returns of just 1.15% and missing the best 40 days would have resulted in negative annualised returns of -2.8%. By staying out of the market in anticipation of a downturn, investors risk missing out on these upswings if, as often happens, they get their timing wrong.

Volatile prospects

However, if we are in for a more prolonged period of volatile and poor performance in markets, there are potential opportunities for investors using passive vehicles. As Smith notes: “It’s fair to say that when volatility picks up, some parts of the market perform better than others – there’s a higher dispersion of returns.”

One way to gain from this greater dispersion is to look at smart beta ETF strategies. These function similarly to normal ETFs but, instead of buying the whole market, they screen for companies that share a certain characteristic or ‘factor’. Hundreds of factors exist, with the most popular being the ‘momentum’ factor (which assumes that stocks that have gone up in price lately will continue to do so in the future, for some time at least) and the ‘value’ factor (which looks for shares trading at discounted values on the assumption that underpriced shares eventually recover).

Opting for certain factors in a more volatile market should, in theory, provide investors with better returns. As Caroline Baron, head of ETF sales, EMEA at Franklin Templeton, explains: “Unlike a market-cap index that goes up and down with the market, some smart beta strategies will help investors get better risk-adjusted returns and/or some enhanced diversification, ensuring a smoother ride in those difficult markets.”

The issue, however, is knowing which factor will see outperformance. Right now many investors are pointing towards value. McLean notes: “The value factor has trailed market returns during this bull market, as high-growth technology businesses have attracted significant investor interest.”

New routes to value

That now appears to be changing, however, with tech stocks perhaps running out of steam and a changing macroeconomic environment. “Capturing the value factor through smart beta vehicles offers a direct and often low-cost solution, but it is vital that inherent biases are well understood to avoid an over-reliance on specific stocks, sectors or regions,” says McLean.

Dimitar Boyadzhiev, a passive strategies research analyst at Morningstar, suggests two possible value ETF options: the UBS MSCI USA Value ETF and the iShares Edge MSCI USA Value ETF. “Both represent efficient and diversified access to cheaper stocks,” he comments.

Alternatively, investors could opt for ETFs with screens for certain industry sectors. Just as certain share ‘factors’ may provide stronger performance, so too may certain sectors. According to Wei Li, head of iShares investment strategy, EMEA at BlackRock: “Sector calls can be both tactical and structural, and the relative ease of ETF trading allows for both strategies to be easily implemented.”

Li says the financial sector may be poised for better performance – the result of the US Federal Reserve continuing to hike rates. To gain access to that sector, investors could consider the iShares S&P 500 Financials Sector UCITS ETF.

However, Smith sounds a note of caution against such strategies. “The risk of picking parts of the market when volatility rises means you have a higher chance of underperforming by a big margin.” He recommends that, where possible, investors should take a broader market-cap approach. “It’s very difficult to anticipate factors. It can be very cyclical.”

Norton also warns against these strategies. “Just because the market has fallen does not mean that a particular investment style will perform better or worse going forwards,” he says. He takes up the example of value strategies. While noting that growth has performed well for a very long time, he argues that “no one knows when that shift to value will happen”. Indeed, value investing has been in a bear market for the past 11 years.

However, he adds: “If an individual has a strong conviction that a particular strategy such as value will do well, then ETFs are a good way to access it as they are low-cost and transparent. But we would recommend that factor (or smart beta) exposure should only make up a small proportion of an investor’s portfolio.”

Similarly, Webster-Smith concludes that while “such investments can also be a useful and efficient way of expressing a macroeconomic view on a tactical basis”, such investment types “should only be seen as useful in the context of inclusion within larger balanced portfolios”.

Time to get active?

During periods of volatility, it is o­ften argued that active managers should shine. While a bull market li­fts all portfolios, in a more challenging climate the discerning skills of active managers can better navigate the choppier waters.

They can do this, it is said, by being able to look beyond market turmoil and identify strong individual businesses, seek out oversold and therefore undervalued shares, and move to more defensive assets if needed. As Vanguard’s James Norton notes: “Active management sounds really appealing in ‑ at or down markets. The theory is that managers can protect from the worst of the falls.”

Unfortunately, the evidence shows this is not always the case. Vanguard looked at the three bull markets and two bear markets since 1998. During the bear market a­fter the dotcom bubble, only 40% of active managers outperformed the market, while in the bear market from November 2007 to February 2009, just over half outperformed. “There was no systematic tendency for active managers to outperform in any particular conditions,” he concludes.

There are still good reasons to invest in active funds and trusts. However, it appears that superior returns in volatile or falling markets are by no means guaranteed.

This article was written in late October for the December print edition of Money Observer. Market data and share prices are likely to have since changed.

Subscribe to Money Observer Magazine

Be the first to receive expert investment news and analysis of shares, funds, regions and strategies we expect to deliver top returns, plus free access to the digital issues on your desktop or via the Money Observer App.

Subscribe now

Add new comment