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Is it the end for passive outperformance?

The Week | Adviser-Hub | Is it the end for passive outperformance?

Over the past five years, investors have only had to be ‘in it to win it’. They haven’t needed to be particularly skilled, or find the right companies, or even be any good at asset allocation, an index investment in both bonds and equities has served them pretty well. Is this about to change?

  • Global liquidity conditions have driven all markets higher
  • Flows into passive funds may have driven key index components higher
  • Passive outperformance may be tested in a new environment

There are a number of reasons why investors haven’t had to be particularly nuanced over the past few years. The first is that global liquidity conditions have driven everything higher. Quantitative easing has supported financial markets across the board. It has also disproportionately supported larger companies, who have benefited from investors moves out of bonds.

Equally, in many markets, the largest stocks in the index have been those that have performed best. For example, in the US market, the technology giants of Facebook, Amazon and Alphabet (owner of Google) are the largest in the index and have also been the top performers.

“Passive outperformance of active - and vice versa - has always tended to be cyclical. If flows into passive funds slow down, those companies that form a large part of the index may see less support. ”

This may be cause or effect. It may well be that increasing flows into passive has helped drive these stocks higher. Passive funds grew 4.5x faster than active funds in 2016, which, by extension, should help those companies that feature highly in passive indices and support performance.

But can this last? The liquidity environment is changing. Interest rates are rising in the US, there are signs that the ECB may be about to rethink its quantitative easing programme. Markets are already wobbling, particularly in the absence of any fiscal stimulus programme in the US, which now appears less and less likely.

Passive outperformance of active - and vice versa - has always tended to be cyclical. If flows into passive funds slow down, those companies that form a large part of the index may see less support. For the time being, there is no sign of this happening and the trend towards passives continues, but with markets trading sideways, investors may once again start to seek out stockpickers. .

Active managers are currently more cautious. Many have higher cash weightings and are waiting for opportunities to buy back into markets at better prices. This has hurt in an environment where investors seemed agnostic to price, but may serve them better as equity markets start to show weakness.

The truth is, in an environment where markets are wobbling, passive funds are a blunt tool. They can do little to protect investors from market falls. Active funds should come into their own.

 

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