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Passively active risk

Global markets have been sucked into a risk on, risk off environment since 2008. Correlations between risk assets will be much higher than usual in a risk on, risk off environment.

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When risk assets are highly correlated, investment managers struggle to find alpha, and nowhere has it been more painful than in the equity space. The result is clients can’t understand why they should pay the higher fees for active management when results are no better, and in many cases worse, than when investing passively. Consequently, large sums of money have moved from active to passive equity mandates. In fact, as the Financial Times reported, according to ETFGI the first two months of this year alone has seen over $130 billion being ploughed into ETFs. US stocks, buoyed by Trump’s promises of tax cuts and increased spend, have seen US equity ETFs feast on investors’ money.

It is not only active managers who should be worried about the one way flow (as oft reported on by some gleeful commentators).

The significant flow of funds from active to passive mandates implies a risk that is not widely understood. Passive equity funds pay no attention whatsoever to valuations. They simply buy the constituents that make up the index. It is therefore conceivable that, over time, the largest companies will become disproportionately expensive as a result. I have looked at projected PEs on the ten largest U.S. companies and conclude that, whilst valuation is not a major issue yet, it certainly has the potential to become one.

It is not just in mature markets like the U.S. that passive investing promises to cause problems down the road. Foreign investments, many of which are passive, are flowing into China in big numbers. That illustrates how passive investing can potentially reward bad behaviour. China, after all, has the world’s biggest crisis of corporate governance. Recent scandals have highlighted:

  • Failure to enforce securities laws
  • abuse of conflicts of interest in state-owned enterprises;
  • seriously deficient property rights.

In other words, any investor in a passive fund investing in China will be exposed to serious corporate governance risk. When companies in the index raise capital, as they do regularly, that exposure will increase. To make matters worse, when China is eventually added to the MSCI EM index, the affect will be accentuated.

For the very same reason that capital has parted company with active investment managers in recent years, growth stocks have outperformed value stocks. Only in 2012 did value outperform growth. In all other years since 2008 value underperformed.

The reason is straightforward. As ever larger amounts of capital are managed passively, more and more capital flows towards the largest companies, and the majority of those are growth stocks – not value stocks. The underperformance of value vs. growth has created significant opportunities in the value space. Having said that, in the short term, the drive towards passive investing may cause the underperformance to continue for a while longer.