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Passive Investments: Far From Perfect

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Over the past few years the investment management paradigm has shifted. An increasing number of retail investors have incorporated passively managed investments in their portfolios. Investment management firms have responded by adding new and exotic passive investments to their product lineups.

The below EPFR Global graph illustrates this shift in investor sentiment. Since 2014, U.S. passive equity funds have brought in over $600 billion in assets while U.S. active equity funds have seen the exact opposite happen: outflows of nearly $800 billion.

Figure 1

 Active vs. passive cumulative flows. Source: EPFR Global

Below, we take a closer look at the active vs passive investment argument, which asset classes provide opportunities for financial advisors to find alpha, risks with passive investments, and will this trend continue in 2017 and beyond.

Followers of the Random Walk theory have argued that markets are efficient and that consistent manager outperformance has more to do with luck than skill, which has led many to passive investments. A renewed emphasis has been placed on investment management fees, which has caused a price war, benefiting passive investments. Investors are also attracted to passive investments due to their increase in tax efficiencies compared to active investments.    

However, there is more to the story that financial advisors must consider when comparing active investments to passive investments.

The popularity of passive investments has taken off since the bottom of the credit crisis, as figure 2 shows; it’s easy to see why. When looking at a universe of all U.S. equity mutual funds, the Russell 3000 index ranks in the top half and in some cases the top quartile.

Figure 2

Manager vs. Morningstar All Domestic Equity Managers: Return Rank

When one peels away the layers and looks at the individual asset classes, one can find opportunities for active management. For starters, small caps and European stocks tend to provide investors opportunities to add alpha to their portfolios. Until recently, the Russell 2000 Value index has ranked in the bottom half of all small-cap value mutual funds since the beginning of 2009 (figure 3).

Figure 3

Manager vs. Morningstar Small Value: Return Rank

Investing overseas provides additional opportunities for active investors, for example, diversified emerging markets. Figure 4 shows that the return rank for the MSCI Emerging Market index is very inconsistent, which provides active managers the opportunity to outperform more consistently.

Figure 4

Manager vs. Morningstar Diversified Emerging Markets: Return Rank

Passive investments are not immune to risk, and to some investors, the risk they are most concerned with is downside risk. Above, we looked at the return ranks of the indexes within a universe of like mutual funds since the bottom of the credit crisis. This time period marks the second longest bull market in history, which recently has been void of volatility – a perfect storm for passive investments. Bull markets don’t last forever and we must prepare ourselves for a correction, or worse yet, a bear market, so it’s important to flip the script and look at how these indexes perform during a crisis.

Passive investments track a particular index, so when a market sells off, the passive investment is unable to take defensive measures such as investing in derivatives and/or increase their cash position to soften the blow.

Let’s take a look at the large value asset class, which was hit especially hard during the credit crisis (November 2007 – February 2009). Had you been invested in a passive investment that tracks the Russell 1000 Value index, you would have lost over 54%. Your pain index, which measures the depth, duration, and frequencies of all periods of loss, would have been just under 23. Passive investors would have felt the pain when comparing their passive investment to the average max drawdown (-51.17%) and pain index (22.01) for all large value mutual funds (figure 5).

Figure 5

Max Drawdown/Pain Index - Large Cap Value Universe

The mid-cap blend asset class provides a similar story to the large value asset class. The Russell Midcap Blend index falls in a quadrant that is characterized by funds with high max drawdowns and high pain indexes, or in short, poor capital preservation skills (figure 6).

Figure 6

Max Drawdown/Pain Index - Mid Cap Blend Universe

The question remains: Will this trend of growing popularity for passive investments continue? Due to the low fees and tax benefits, passive investments will continue to be popular; however, performance-wise, I believe strong active managers have an opportunity to shine moving forward.

Volatility looks to pick up due to the lack of certainty surrounding fiscal policy, while high equity valuations pose a risk for a market selloff. Additionally, low correlations amongst the 50 largest S&P 500 stocks present opportunities for stock pickers. According to JPMorgan, the 3-month realized correlation ending February for the largest 50 stocks in the S&P 500 hit 0.18, while the historical average is just under 0.40. These market indicators are a few of the reasons I believe active investments are prime for outperformance.

Passive investments should be part of every financial advisor’s fund menu, but they are far from perfect. There are risks that come with passive investments, and it is important for financial advisors to recognize these risks before building a portfolio consisting only of passive investments. It is also important to note there are many asset classes that provide financial advisors an opportunity to add alpha to their client portfolios while reducing downside risk.