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The potential perils of passives

14 October 2019 Carolyn Levin, Director – Investment Management, Stonehage Fleming South Africa
Carolyn Levin, Director – Investment Management, Stonehage Fleming South Africa

Carolyn Levin, Director – Investment Management, Stonehage Fleming South Africa

With passive equity funds threatening to take over their active peers in the US, and active managers struggling to outperform the market over recent years, one may be tempted to start switching into passive investments. However, as the global economy potentially heads into more volatile conditions, Stonehage Fleming question whether now would be the correct time to do so.

Passive investing vehicles, be they index tracking funds or their more complicated cousins exchange traded funds (ETFs), divorce investing from economic and company fundamentals. Driven largely by computer trading systems, passive investments pay no attention to individual stocks in an index and the fundamentals driving their prices. Strong bull markets offer the perfect conditions for passive funds to perform well. Up until the end of 2018, US markets had enjoyed a 10-year bull run. It’s not surprising that this period saw a massive increase in the passive investing industry.

In the UK, funds invested in passive equity funds have grown by more than 700% since 2008[1]. Globally the volume of money held in ETFs has soared. Some US$5.74tn was held in ETF assets globally at the end of July 2019, up from less than US$100bn at the turn of the century.[2] When it comes to mutual funds and exchange-traded funds that buy U.S. stocks, those that passively track indexes now hold 48% of the market, according to estimates from Morningstar Inc. It is estimated that they will top 50 percent in 2019 if the current trend holds[3]. As more and more investors pour into passives, managers of these funds are forced to purchase increasing amounts of the stocks included in the index being tracked, driving up their prices. In so doing, the outperformance of passive funds starts to become a self-fulfilling prophecy – as more investors are drawn to passives, the passive funds purchase more index stocks which in turn drives up the prices of index stocks and the return of the passives.

As volatility returns to the market, or worse, when the bears come calling as they inevitably will, will passives continue to perform well? Stonehage Fleming is not alone in its belief that the US economy is now in the late part of the cycle and that markets are heading into more volatile territory.

If a downturn ensues, investors will be piling out of their passive investments as quickly as they piled in and just as some stocks were disproportionately bought because of index funds and ETFs, so will some be disproportionately sold. In such situations, the fall in prices experienced by passive funds where stocks had been purchased and held indiscriminately will likely be greater than that experienced by active portfolios where stocks had been selected based on strong fundamental characteristics. As market dispersion increases and stock prices once again become driven by fundamentals, one is likely to see a portfolio of well selected active managers return to outperforming passives.

Either way, if the bull market continues or if a downturn is on its way, the mispricing that passive investments are creating in markets provides real opportunities for active managers.

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