The active versus passive debate for charity investors
Passive investments have been used for decades, but in recent years many investors, including charities, have turned to passive strategies on a scale never seen before. The huge growth in passive investment is one of the defining features of the current bull market and is helping funnel flows into areas that are already very popular. However, in certain asset classes and investment styles this increases the likelihood of significant losses when the trend changes.
Charity trustees have a duty to act in the best interests of their charity; they also need to bear in mind the impact of their choices on beneficiaries. The debate over whether to pursue active or passive investment strategies could make a significant difference to a charity’s costs and risk profile – and thus the returns available for use by the charity.
Active asset management uses a human element to “actively” manage a fund’s portfolio, using research and judgment to make decisions on which securities to buy, sell or hold. In contrast, passive investments are low cost strategies that typically aim to track an index, such as the FTSE 100 or the S&P 500 index.
Mixed situation about passives
Passive managers have expanded their offerings to include active-style strategies that require frequent rebalancing, but are marketed as passive, such as factor investing. Investors need to be very aware of the underlying index their passive fund is tracking. Different providers may well offer the same named passive trackers though the underlying indices can be very different.
Passives are beginning to have considerable impact on the marginal pricing of stocks, market volatility, cross-correlations and price discovery.
There is no strategy or asset class in the world that can’t be ruined by having too much money thrown at it, and a fundamental concern with passives is that they can channel money into areas that have already performed very well. Are investors confusing low cost and no active decisions with low risk? Moreover, passive management makes no attempt to distinguish attractive from unattractive securities - and makes it more difficult for an investor to target a specific required return to meet an income requirement for example, as this would usually entail taking a certain degree of active risk.
The case for passive investment
In a lower expected return environment, the low fees involved in passive investing are clearly attractive. Many of these vehicles are very large, and therefore benefit from considerable economies of scale. Passives do not incur the usual expenses required for active management. and can engage in strategies which can help reduce their cost base. Examples such as lending stock to short sellers for a fee and making a profit on the bid-offer spread on their high daily turnover are often employed as cost reduction strategies.
Disappointment surrounding active manager performance has further driven investors towards passive vehicles, as the current bull market has led to a number of active styles - such as value investing - struggling to keep up with a momentum driven market. In addition, too many active funds have pursued tight benchmark tracking strategies and thus the active industry as a whole has failed to add enough value through outperformance to justify its higher fee structure.
The popularity of passives has also been encouraged by the low interest rate environment that we’ve experienced since the global financial crisis. The collapse of bond yields has forced risk averse investors into equities to replace their income shortfall. These investors have favoured bond proxy and low volatility strategies, and as these have grown in popularity, they have built a self-perpetuating momentum of their own.
Bull markets and passive
It is argued that many of the equity market returns since 2009 have been driven by central bank policy, quantitative easing and low interest rates, and that these factors have overridden other considerations. As is often the case when optimism returns to markets, many of the higher risk stocks were those that grew the fastest.
However, actively managed portfolios grew at a less dramatic rate than portfolios invested in index tracker funds, partly due to human fund managers being much more aware of potential risks and using caution when investing. Index returns can be skewed by the excess returns of a few stocks, the rise of the impact of the FAAMG (Facebook, Amazon, Apple, Microsoft, Google) stocks on the US markets being a good example. Apple, Microsoft, Amazon, Google and Facebook currently make up around 17% of the S&P 500 index.
It is important to remember that no bull market has lasted forever, nor is there any reason to suppose that the bear market has been banished indefinitely. Over the long term, valuation is the core driver of the market, not sentiment, yet the more a charity pays for each share, the harder it is to generate long term profits. Market indices are substantially higher than they were in 2009, which suggests expected index returns in the coming years are likely to be far lower than in the recent past.
Planning for the future
Timing is vital in capital markets. Many charity trustees focus on near term performance relating to the last three to five years. However, what trustees must consider is the importance of seeking data that covers both bull and bear markets. The current bull market extends back to 2009, but to include a full cycle you should include the last bear market and as such data must start in 2007, the peak of the last cycle - meaning that a complete and meaningful picture is shown. That is thirteen years of data, rather than five.
To illustrate the significance of this, we should consider what happens over the course of a market cycle. Towards the end of a bull run, the range of successful investments begins to narrow. Investors find themselves increasingly funnelled into a narrower range of assets, placing more and more of their investment into a few selected crowded stocks. This naturally increases stock specific risk within a portfolio, an undesirable situation for charities seeking lower volatility and consistent returns.
While it is not known when this bull market will end, trustees seeking outperformance over the long term are well advised to select investment managers that can demonstrate respectable performance during market lows, as well as market highs.
Managing capital loss risk
Long term investors would see risk as being permanent loss of capital rather than volatility or benchmark tracking error. They can manage this risk in two key ways.
Avoiding big losses is more important than picking big winners. In a period of technological change, a large number of companies and sectors face technological disruption. Highly indebted companies or those with poor corporate governance are especially vulnerable. Many businesses are facing material threats even though their shares are still trading on very high multiples.
Often these risks are not being reflected in share prices and it is possible that passive investing is supporting the share prices of companies whose fundamentals do not support current valuations, thus creating price distortions. By being more selective with stock picks, focusing on high quality companies operating in profitable and growing industries, one can exclude high risk businesses which would be impossible to avoid when investing through index trackers.
Portfolio balance is the second way that one can seek to reduce the risk of permanent loss of capital. Portfolios can be tilted to the outcomes seen as the most probable but should be constructed to ensure a spread of exposures that would do well in the event of the unexpected.
When considering an appropriate investment strategy, trustees must ask themselves: does blindly allocating capital according to market capitalisation, while concurrently ignoring valuation measures and business fundamentals, really accord with the fiduciary duty of trustees?
Historically, passive management has peaked in popularity near the top of the cycle. In contrast, active managers, who can be more selective with their portfolios, tend to perform better than passive strategies in down markets, particularly with regards to protecting capital.
Quality active management
So the conclusion has to be that there is value to be found in a quality actively managed portfolio, particularly during more volatile periods for markets. It is undoubtedly true that there is value in holding passive investments given that their structure can offer exposure to specific sectors or geographies at very low cost. However, these should be viewed as most beneficial when used tactically, as part of the asset allocation of a sensible and well diversified actively managed portfolio.
