The Perils Of Passive: A Timely (But Friendly) Reminder

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The Perils Of Passive: A Timely (But Friendly) Reminder

MICHAEL LABELLA, CFA
HEAD OF GLOBAL EQUITY STRATEGY

JOSEPH S. GIROUX
PORTFOLIO MANAGER

OCTOBER 09, 2018

The popularity of passive investing is on the rise but is it all it's touted to be? In recent  years, investors globally have turned to passive investment strategies to gain core global equity exposure and the size of the shift is significant. At the end of 2017, passive investments represented 20% of total global assets under management (AUM), almost doubling the 11% share they had in 2008. The trend towards passive is gaining momentum, with a record 25% increase in AUM during 2017[1], making it an industry trend that needs to be understood.

Passive investing is widely used among global institutional investors. A survey of 153 pension plans in 25 countries with a total AUM of approximately US$3.4 trillion, conducted by CREATE-Research, indicated that 66% of the plans that responded already utilise passive allocations, while 15% of the respondents indicated that they are now in the implementation phase.[2]

WHY PASSIVE?


Advocates of passive investing point to transparency, liquidity and low cost as the main advantages of allocating to ETFs or other products that track market- capitalization weighted indices, as well as some skepticism on the ability of active managers to consistently outperform their benchmarks. This growth in passive strategies has also been fueled by an unusually benign market environment for passive investing – consistently rising equity prices coupled with low volatility. Following the Global Financial Crisis, equity markets have generated over 300% returns[3]  while volatility has receded to historically low levels amid concerted efforts from major central banks to lower interest rates and engage in stimulative monetary policy.

Interestingly, this nine year bull market in global equities has obscured some of the significant shortcomings of the capitalization-weighted passive equity strategies.
As we move into the later stages of this bull market, against a backdrop of historically high equity market valuations and low expected returns, it is important to revisit these shortcomings as the favorable conditions that have supported the growth of passive investing will not last forever.

THE PERILS OF PASSIVE


The main perils of passive investing are related to certain key features of index construction. Namely, the reliance on security prices to determine portfolio weights and the lack of risk management mechanisms employed in the construction of market-capitalization weighted indexes. As a result, passive equity strategies can miss opportunities to generate returns by ignoring key fundamental and behavioral information, while taking on significant investment risks (concentration risk, unintended exposures and potential drawdowns) which appear heightened at the current stage of this extended market cycle.

Active strategies, focused on assessing the bottom-up fundamentals of individual securities and in managing portfolio risk and exposures, may mitigate some of these perils and thus have an important role in a core global equity allocation from both a returns and a risk control standpoint.

PERIL #1 - MISSED OPPORTUNITIES


Passive equity portfolios typically track capitalization- weighted indices created via discretionary committees (S&P/Dow Jones) or rules-based methodologies (MSCI and Russell). The underlying constituents of capitalization-weighted indices are determined mainly by price and outstanding shares; no forecasts of future returns or intent to align the portfolio with investor goals are taken into consideration. Passive strategies ultimately rely on the assumption that markets are efficient and that current prices reflect all existing information, despite an extensive body of work in behavioral finance documenting the pervasiveness of inefficiencies in financial markets[4].

By focusing on prices, market-capitalization indices ultimately absorb investors’ cognitive and behavioral biases. Cognitive limitations lead investors to make mistakes. For example, some investors prefer familiar investments such as securities of the company they work for or the country they live in (also known as the “home bias”). Furthermore, most investor decisions are heavily driven by human emotions: fear and greed. Fearful investors sell indiscriminately upon any indication of economic, financial or political turmoil. Greedy investors buy into any fad, for fear of missing out, and at any price. These types of behavioral biases result in systematic mispricing of stocks, hence current stock prices are not always the best possible estimate of future prices and thus returns.

By contrast, disciplined investors can utilize information that is not included in current stock prices to make a discerning estimate of future prices, market risks and forecast stock returns. Fundamental information on a company can help identify securities that are undervalued, ie priced below their intrinsic value as suggested by predictable future cash flows. When economic growth becomes scarce, investors tend to overpay for it, thus bidding up the price of stocks that are expected to exhibit growth in the future. Overvalued stocks eventually become less attractive than their undervalued counterparts –  growth expectations ultimately slow down and/or are found to be overstated — and prices mean revert, leading to an appreciation of those stocks that had been previously overlooked. From a long-term perspective, what an investor pays for growth matters a lot.

Combining fundamental data with market sentiment metrics allows investors to exploit these mispricings. Company fundamentals serve as an anchor to price growth, while business momentum and market sentiment serve to identify catalysts to close the valuation gap. An attractively valued stock of a company lacking in business momentum may not appreciate; it is cheap for a reason. Likewise, a stock with strong price momentum but not anchored on a solid business model may not be a good long-term investment. Over time, this approach of combining valuation and momentum, even in its most naïve conception, generates excess returns (Exhibit 1).[5]

Exhibit 1: Annualized performance of simple Value and Momentum blends relative to Market-Capitalization Index in different universes, since inception

Source: MSCI. “Value and Momentum blends” are based on MSCI Select Value and Momentum Indices for the different universes.
The MSCI Select Value and Momentum indices combine MSCI Momentum and MSCI Value Index. The construction methodology is available
at https://www.msci.com/msci-select-value-momentum-blend-indexes. Inception for World ex-USA and USA is May 31, 1999. Inception for EM is May 31, 2007.

While value and sentiment have been identified as sources of systematic returns, the implementation of these ideas varies significantly across strategies.
More nuanced approaches include a broader range of value and sentiment indicators. For example, instead of measuring sentiment utilizing recent price trends, data on put/call ratios, short interest and analyst expectations, may offer a more holistic approach to capture investor sentiment. The approach can be further enhanced by using different factors in different sectors (as not all information is equally applicable and/or relevant across sectors, industries and/or regions at each point in time), as well as dynamic weighting across factors based on factor effectiveness, and geared towards avoiding crowded trades.

PERIL #2 - CONCENTRATION RISK AND UNINTENDED EXPOSURES


Investors utilizing market-capitalization weighted indices to build their core equity allocations are taking on significant concentration risks. By definition, the larger components of market capitalization indices carry higher percentage weightings, while the smaller ones have smaller weights. Per this design, market capitalization indices are biased in favor of larger stocks, sectors and/ or countries. While broad equity indices are often considered highly diversified strategies due to their large number of stock holdings, closer examination reveals that a small number of stocks, sectors and countries ultimately dominate the composition of the index (Exhibit 2).

Exhibit 2: Weight of largest 10% of stocks, sectors and countries vs bottom 90% in global equity index

Source: Bloomberg and QS Investors as of March 30th 2018. Note: data for MSCI ACWI Index. Total number of stocks is 2,485;
Total number of sectors is 11 and total number of countries is 48.

In spite of its apparent breadth and diversification, the global equity market-capitalization index is highly concentrated. The effective number of stocks[6] for the 2,495 security benchmark is 405 stocks (as of March 30, 2018).

Exhibit 3: Bubbles and busts over time: sector/country weight at the peak and end of the bubble and cumulative losses during these episodes

Sources: Bloomberg, MSCI, Standard and Poor’s. Past performance is no guarantee of future results. All returns are cumulative rather than annualized, and calculated on a monthly basis.
Market indexes for each sector are Japan: MSCI EAFE; S&P 500 Info Tech, Financials and Energy S&P 500. All index and sector returns reflect price appreciation/depreciation;
returns due to dividends are excluded. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Concentration risk is especially pervasive during market “bubbles” (Exhibit 3):

  • Japan’s “Lost Decade” - Expectations over the Japanese economy during the 1980’s resulted in a tremendous growth of Japan’s participation in the developed market’s equity index. As investors started to realize that these expectations were disconnected from its economic fundamentals, Japan’s participation in the index fell dramatically, causing a 58% drawdown.
  • Internet Bubble - The 2001 Tech bubble and bust consisted of a similar phenomena, where new technology businesses were not valued appropriately, with their worth grossly overestimated, causing a 74% drawdown as expected earnings did not materialize.
  • Global Financial Crisis - The growth of the Financial sector in the index during the early 2000s was fueled by a market that was mesmerized by new financial instruments (CLOs, CDOs and other structured credit products) that investors deemed riskless. The collapse caused another 74% drawdown and a dramatic reduction of the Financials sector.
  • Energy Bust - The Energy boom and bust in 2015 was driven by innovation and the disruption generated by fracking technology which eventually ended, causing a supply and demand imbalance in oil markets and a 30% drawdown in the index.

In each of these cases, passive investors rode the growth and demise of each market segment. Active managers with a disciplined process are able to mitigate the impact of bubbles and busts, by reducing the behavioral biases (in this case investor greed and/or herding) in their investment decisions and employing risk management mechanisms to further reduce the impact of market shocks.

The risk and return profile of cap-weighted portfolios is also heavily influenced by unintended risks and factor exposures, which can be both cyclical and non- diversifying. For example, passive indices will adopt a higher beta to Momentum during trending markets, such as in the early 2000s leading into the Global Financial Crisis, and during 2017 (Exhibit 4). These periods are often followed by large drawdowns, as markets rotate away from a particular trend. Similarly, exposure to other factors varies over time, which may leave investors’ portfolios vulnerable to style rotations in the market.

Exhibit 4: Global equity beta to MSCI ACWI factor indices

Source: eVestment.

Concentration and unintended exposures increase the potential for drawdowns. Passive investors participate in 100% of the index drawdown which may set them back significantly in regards to their investment goals,especially when considering the asymmetry of returns - recovering from a 50% loss requires a 100% return (Exhibit 5).

Exhibit 5: Risk characteristics MSCI ACWI Index

Source: Bloomberg as of March 30th 2018.

In the last 30 years, the MSCI ACWI Index saw 22 annual positive returns, however, annual intra-year drawdowns averaged -10% (Exhibit 6).

Exhibit 6: Intrayear drawdown MSCI ACWI

Source: eVestment.

THE POTENTIAL OF ACTIVE


In addition to benefiting from potential return opportunities that market-capitalization indices may miss, a disciplined active investment approach can create a superior core equity portfolio that maximizes exposure to factors that can outperform, while minimizing exposure to other risk factors. Even investors not willing to take on active risk relative to their benchmarks can improve the risk profile of their equity portfolios by adding an allocation to an active strategy. Security selection within sectors and countries can help manage factor exposures and capture diversification benefits. Active risk management and portfolio construction techniques are conducive to a truly well-diversified portfolio and can help circumvent unintended risks while attaining the most favorable possible trade-off between return and risk. We believe that a well-diversified portfolio of companies, with attractive valuations relative to their peers and positive sentiment catalysts that can close the valuation gap, tends to generate better risk- adjusted returns than market cap weighted indices.

ACTIVE AND PASSIVE


All that said, it’s still a fact that not all active managers add value or manage risk efficiently. There is enormous variation among active managers and this actually makes “generalized arguments” about active management moot. But the shortcomings, or perils, of passive investing invariably apply to all passive equity strategies. As always, it is incumbent upon investors to understand the specificities of any manager’s investment process, portfolio construction and performance characteristics. The salient point is that active management offers an opportunity that can be complementary to passive strategies and can help achieve excess returns.Adding actively managed strategies to passive core global equity allocations may alleviate some of the shortcomings of a fully passive approach. Given we are nine years into a bull-market in global equities and in light of stretched valuations, an accumulation of large concentrations in market indices (namely in growth/momentum stocks, technology, China and US equities) and low expected returns going forward, this may be a good time for investors who have been focused on the benefits of passive investing to be reminded of its perils as well.

*This article is also available on Centre For Investor Education

1 Boston Consulting Group (BCG), “Global Asset Management 2018. The Digital Metamorphosis”, July 2018. https://www.bcg.com/en-us/publications/2018/global-asset-management-2018-digital-metamorphosis.aspx
2 CREATE-Research (2018), “Reshaping the Global Investment Landscape”. http://www.create-research-uk.com
3 Based on MSCI ACWI Index returns since February 28, 2009 and as of March 30, 2018.
4 Much of the work on inefficiencies in financial markets was pioneered by Robert Schiller. His work, showing the disconnect between economic fundamentals (earnings and dividends) and stock market prices earned him a Noble Prize in Economics in 2013. See Schiller, R. (2002) Market Volatility, The MIT Press.
5  For a review of Value investing, see Greeenwald, B., Kahn, J., Sonkin, P. and van Biema, M. (2004) Value Investing: from Graham to Buffet and Beyond, Wiley Finance. Jegadeesh and Titman (1993) “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency”, The Journal of Finance, Vol. 48, No. 1 is one of the seminal studies on momentum. Asness (1997) and Daniel and Titman (1999) Asness et al. (2013) show that within and across asset classes, momentum and value are negatively correlated and illustrate the gains associated with combining pure-play momentum and value portfolios. Asness, C. S. (1997). “The Interaction of Value and Momentum Strategies,” Financial Analysts Journal; Daniel, K. and Titman, S. (1999). “Market Efficiency in an Irrational World,” Financial Analysts Journal 55(6); and Asness, C. S., Moskowitz, T. J., and Pedersen, L. H. (2013). “Value and Momentum Everywhere,” The Journal of Finance 68(3) analyse combinations of value and momentum.
6 Effective number of stocks is a measure of index concentration and ranges between 1 (for a single stock) and the number of stocks in the index (for an equal-weighted index). Generally, the lower the EN, the more concentrated an index.

IMPORTANT INFORMATION
This material is intended for informational purposes only and it is not intended that it be relied on to make any investment decision. It was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or QS Investors, LLC to enter into or arrange any type of transaction as a consequence of any information contained herein. QS Investors, LLC does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of QS Investors, LLC, the Issuer or any officer, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person. The views expressed in this document constitute QS Investors’ judgment at the time of issue and are subject to change. The value of shares/units and their derived income may fall as well as rise. Past performance or any prediction or forecast is not indicative of future results. This document is only for professional investors. Investments are subject to risks, including possible loss of principal amount invested.

QSCR 18260 (October 2018)

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