Investors who have invested the core of their portfolio into passive funds could find themselves invested in the wrong type of strategies as market conditions change, according to T. Rowe Price’s Yoram Lustig.
Passive strategies have soared in popularity over the past decade as a flood of money from central banks has lifted all asset classes.
Over the past decade, tracker funds under management has risen from £30.7bn in 2009 to £218.3bn as of October 2019, according to data from the Investment Association.
Source: Investment Association
Yet, while their low costs and strong performance have enticed many investors, Lustig –head of multi-asset solutions for Europe, Middle East & Africa at T. Rowe Price – said that investors may need to revisit their allocations to the strategies.
“The strong returns of passive strategies since the financial crisis have been driven by central banks,” said Lustig. “Ultra-low and falling interest rates, combined with trillions of dollars of quantitative easing [QE], have caused valuations to balloon since 2008.
“Market returns – beta – upon which passive strategies are built, have been much higher than excess returns – alpha – during this period.”
He added: “This era is almost certainly over, however. There is a limit to how much more QE central banks can administer, its impact is questionable, and given current valuations, expected returns of equities and bonds are diminishing – or at least they are much lower than market returns since 2009.”
However, even if QE is extended it is unlikely that interest rates will fall significantly posing difficulties for markets to replicate the kind of returns seen since the crisis.
“When beta return is 10 per cent, an alpha of 2 per cent is nice to have, but not essential. When beta return is 5 per cent, an additional 2 per cent from alpha could be critical,” he said.
“In this environment, investors will face the choice of either accepting lower returns or adopting a different strategy in pursuit of similar returns.”
In an environment where central bank money has lifted all assets, selectivity became less important, the multi-asset specialist said. However, as the impact of QE begins to recede, cross-sectional volatility – the spread of performance between different sectors and securities – is also likely to return benefiting active managers.
“When all securities move in the same direction, active management cannot add value; on the other hand, when returns of securities diverge active management can add value,” said Lustig.
“We are likely to be heading into an environment where active management is not only important, but also has more opportunities to add value.”
Additionally, macroeconomic headwinds – such as the US-China trade dispute and Brexit – are likely to bring added turbulence to markets, according to Lustig.
“Considerable rotation within sectors and asset classes can be expected,” he said. “In this environment, passive strategies are likely to perform less well than they have during the long period of relative stability and growth since the financial crisis.”
Indeed, some investors’ perception of passive strategies as a risk-free way to invest may also need to be reassessed, the T. Rowe Price multi-asset solutions head added.
Lustig said given that most equity indices are weighted by market capitalisation, passive strategies tracking them is “effectively a bet that the most recently successful companies will continue to be successful”. However, history shows that is often not the case.
Passive strategies may also make it more difficult to be on the right side of disruptive change, according to the multi-asset specialist.
“Kodak, Nokia, Xerox, Blockbuster, and Yahoo were all giants in their respective fields that failed to identify disruptive forces and lost,” said Lustig, adding that there is no guarantee that today’s giants – such as Amazon and Apple –will continue to perform well.
“These names may, of course continue to perform well over the next decade and beyond, but relying on them to do so is an active bet, not a passive one – and it is important that investors are aware of this.”
A good active manager with a keen sensitivity to change and disruption, he said, could actively tilt the portfolio to avoid disrupted firms and also benefit from the disruption.
Nevertheless, Lustig said that it is not “wrong” to invest in passive strategies nor is he suggesting that they will not have a role to play in portfolios going forward.
“Passive strategies will very likely continue to perform an important function in investor portfolios, albeit in a different way than in the recent past,” he explained.
“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: Active strategies may be used to make the core of the portfolio work as hard as possible, while passive strategies could be used primarily for thematic satellite investments.”
In such a way, active strategies may be held for longer, he said, while thematic passive allocations can be swapped on a more regular basis.
“These developments will become clearer over the next few years,” Lustig concluded. “In the meantime, investors seeking to position themselves for the period ahead may benefit from at least re-examining the role that passive strategies have in their portfolios as the impact of central bank stimulus fades and consider how active strategies may be deployed more effectively to help them continue to generate strong returns in the future.”