Why passive funds are not a low risk portfolio solution
Dominic McCormick explains why going passive is not a low risk portfolio approach.
Outside of cash and term deposits, passive funds – either those replicating market indices or those providing certain ‘factor’ exposures to traditional asset classes – have dominated the significantly lower retail asset inflows in recent times.
The greater use of passive funds to build portfolios – often using passive funds exclusively – seems to be driven by two key elements.
- A focus on low costs in a difficult investment environment where various participants in the wealth management chain – especially financial planners and dealer groups – are focused on lowering the cost of the investment ‘piece’ to at least compete with industry funds.
- The perception that passive funds and passive approaches provide low risk portfolio approaches that have little chance of disappointing investors in a major way compared to active solutions, and therefore provide greater comfort to investors, financial planners and dealer groups.
The low cost focus has already been widely discussed, and if all other things were equal, lower investment costs would obviously be preferred.
However, in the real world all other things aren’t equal, and it is after-cost (and depending on the structure, after tax) returns that ultimately matter.
Obsessing about costs alone is likely to lead to the neglect of a range of important issues that can impact the robustness of the portfolio construction approach (eg, adequate diversification, structural issues in asset classes, asset bubbles, achievable alpha, etc).
However, I do not intend to focus on the cost drivers for using passive investing today.
In contrast, there has been little discussion of the widely accepted view that passive funds and portfolios (incorporating both passive sector funds and a passive approach to asset allocation) are attractive because they represent ‘low risk’ portfolio approaches that have little chance of disappointing investors in a major way – ie, they prevent financial planners blowing up their clients.
However, depending on how you view risk, I believe passive portfolios can be considerably riskier than a well constructed active portfolio – from both an investment and business perspective.
Of course, it is understandable that dealer groups, financial advisers and investors disappointed with the results of many investment products in recent years – particularly more complex, structured, illiquid or non transparent investments – are attracted to the perceived simplicity of passive investments.
Further, with a range of macroeconomic fears dominating, investors’ defensive positioning means investors and financial advisers are primarily interested in avoiding bad outcomes.
While such sentiments are understandable, the danger is that some dealer groups and financial planners have over-reacted to recent bad experiences and moved towards a relatively small, constrained corner of the total investment spectrum – throwing out many sources of potential added value, increased diversification and reduced risk in the process.
In doing so, I wonder if portfolios built using almost exclusively passive investments and passive asset allocation actually provide the “low risk of getting it badly wrong” that they seem to be seeking.
To step back, one way to look at the investment opportunity set is to divide it into six key sources of potential value added (or subtracted).
- Traditional beta – market returns/risk premiums from the major traditional asset classes, including certain risk premiums within them such as ‘value’.
- Traditional alpha – excess returns from skill in taking advantage of inefficiencies through long-biased investment selection in the major asset classes.
- Alternative beta – systematic returns/risk premiums from assets and strategies outside the mainstream asset classes – eg, certain hedge fund strategies.
- Alternative alpha – excess returns risk from skill in selection/market timing employed in alternative asset classes – eg, global macro funds and private equity.
- Flexible/dynamic allocation within the above components – for example, active asset allocation across the main asset classes.
- Flexible/dynamic allocation across the above components – eg, the decision to increase or decrease the use of passive relative to active strategies.
The key problem with the passive portfolio approach is it is typically focused on the first key source only – static allocations to traditional beta.
Therefore, one is focusing on only a small proportion of the full investment opportunity set in seeking to generate returns and/or to decrease risks for clients.
Of course, I am not suggesting that all the sources of increased returns and/or reduced risks listed above are easily accessible or always available, but that is the point of flexibility to move amongst them.
However, in adopting the passive approach, one has already pre-emptively excluded these other potential sources of added value and is arguably, severely constrained.
Surely from this perspective, focusing only on a small proportion of the investment opportunity set has to increase risk.
However, in talking about risk we need to talk both about clients’ investment risk and the business risk of the financial adviser.
Of course, even investment risk has various dimensions, but on the most simplistic risk definitions such as volatility, passive index funds in equities are often higher risk than many actively managed funds.
Simply because they are more concentrated in terms of sector exposure, more growth-oriented because weightings are driven by market capitalisation and – unlike active funds – are unable to lessen volatility/market risk through strategies such as holding cash or using derivatives when there are limited opportunities.
Bond index funds are arguably even more obviously higher risk, as they are most weighted towards those countries that have issued the most debt.
Even on more relevant measures of risk – such as the risk of permanent loss and/or not meeting absolute/real objectives over time – the above factors normally result in passive funds being higher risk.
All passive funds are promising to do is provide the market or factor exposure and resultant risk/returns, but with no certainty that they won’t suffer large or extended drawdowns, or fail to meet risk-free objectives – even over the long-term.
Recent years have highlighted that equity risk premiums can go missing for as long as decades – a timeframe well beyond the practical long-term investment horizon of many investors.
Indeed, in a recent blog, Ken French and Eugene Fama – the most famous academic proponents of ‘risk premium’ investing – reiterated that it requires 35 years or more to be reasonably confident of achieving a positive equity premium (and the value and small premiums); and even then, they admitted that “positive premiums are never a sure thing”.
Yet users of predominantly passive portfolios are relying almost exclusively on these risk premium returns to preserve and accumulate wealth over a relatively short timeframe.
Of course, there is no guarantee that active funds or active portfolio approaches will deliver a better result, but if done well, these can have the advantages of:
- Being more focused on, or even built specifically towards, the actual absolute or real objectives that most retail investors have;
- Diversifying across a much greater range of assets and strategy risk premiums;
- Being able to skew the portfolio towards those assets and strategies where the risk premiums and opportunities are currently most attractive, or away from those that are not.
It seems somewhat ironic that following a period when many investors have been battered by having too much equity market beta or market risk in their portfolios, the proposed solution is to concentrate almost totally on passive funds that give their clients more of, and only, market beta/risk.
Surely this is a time to be more diversified, not less.
At the very least, investors should be given the full picture describing the pros and cons for a restricted passive approach.
Too often, passive portfolio approaches are promoted to financial advisers and investors using simplistic, heavily biased and occasionally vitriolic arguments against all active management with little, if any, focus on the limitations of the passive solutions themselves or proper exploration of the full investment opportunity set.
There is also the business risk issue of whether financial advisers are acting in their clients’ best interest in offering only, or predominantly, passive solutions.
While the best interest provisions of the Future of Financial Advice changes do not require a person giving financial advice to go through the entire market of all available financial products to find the best possible product, it is unclear what is the minimum appropriate amount and range of financial products and strategies to consider.
Given the narrowness of a pure passive product strategy in the context of the investment universe described above, it is a valid question whether a passive approach will meet this minimum requirement without full and proper consideration of the full range of alternative approaches.
The onus is on financial advisers to look after the range of outcomes for their clients – not just an average return.
The path of returns really matters – especially for those nearing or at retirement – so attempting to build a portfolio with a smoother path of returns is clearly a desirable goal.
There are valid concerns whether a restricted, passive approach utilising just one component of the universe of investment products and strategies is sufficient to be able to attempt to deliver the best outcomes to clients across a range of environments and circumstances.
A financial planner cannot choose a passive solution because they think its simplicity is good for their business; they need to do it because they believe it is good for their clients.
Passive solutions have limitations in the real world of clients with limited investment time horizons which need to be clearly understood.
What about the argument that passive funds ensure that clients will never be bottom of the performance pack, and so reduce the business risk of the financial planner and dealer group?
In my view, this argument is becoming weaker over time.
For example, using index funds didn’t prevent Storm Financial destroying massive amounts of wealth; and while this required excessive gearing, it is possible to perform very badly with passive funds through poor asset allocation – particularly chasing returns of the best performing asset classes and selling out of badly performing asset classes.
Another growing problem is that the psychological benchmark that retail investors use to judge return and risk against is variable over time. In today’s environment, it is increasingly cash or term deposits.
That certainly doesn’t mean the industry should respond by giving them that exposure only, but it does mean it has to be careful about what is promised in the non-cash component of investment portfolios.
Talking about passive funds as low risk because they are unlikely to diverge dramatically versus other conventional funds or market benchmarks is risking disappointment if investors increasingly see cash/term deposits as their primary benchmark.
Further, there is the risk that conventional portfolios (whether using passive or active funds) are coming under pressure from more flexible portfolios with greater investment freedom and oriented more to absolute/real objectives.
Thus, while a traditional diversified portfolio using passive funds is very unlikely to perform especially badly versus a conventional portfolio using standard active funds, there is a much greater probability that it may do badly against the new breed of absolute/real return portfolios – particularly if the current difficult environment continues.
If these more flexible ‘multi-asset’ portfolio construction approaches become increasingly entrenched, then such approaches (and not a traditional asset portfolio) will become the appropriate comparison for many retail investors.
Clients will be unlikely to stay the course in a passive solution if there are different ways of building portfolios that offer a better risk/return trade-off.
Ultimately, passive approaches are reliant on a central assumption that markets and capitalism always work and appropriately reward investors for risks taken over time. Events of recent decades have seriously called this assumption into question.
Some markets have underperformed risk-free rates over multi-decade periods – even what constitutes “risk-free” in relation to sovereign bonds is currently being questioned.
There is a realisation that there is no certainty that asset classes will deliver over long timeframes – especially if one purchases when they are excessively expensive, in a bubble, or subject to major structural headwinds.
Investment is not, and can never be, a “science” the way many promoters of passive funds claim.
Still, perhaps the biggest risk for many investors is not even that passive exposure to growth assets won’t deliver over the long-term – although that risk is certainly getting more attention – but that clients will give up on those growth assets at the very worst times.
Arguably, this may have been happening to some degree recently.
We can debate the active versus passive case for years, but we can be certain that investors who continually buy into booms and sell down in gloom (whether using active or passive funds) are likely to do especially poorly.
While it may be part perception, the ability of an active portfolio to respond to difficult periods suggests that – all other things being equal – investors are more likely to stick with a well managed active portfolio versus a passive one through such difficult times.
It is true that some financial advisers and fund managers do a good job of educating their clients to stick with a passive strategy through thick and thin, but even many of those clients are likely to buckle if the current difficult times continue for an extended period.
The alternative more diversified portfolios don’t offer certainty of better outcomes, but if well run, they offer greater diversification across risks and the ability to respond to opportunities (and manage risk) that the passive approaches don’t.
We are living in a world where that full flexibility is required.
Now seems to be one of those times when investors and financial advisers have learned the wrong lessons from recent history, and may be putting themselves in more, not less, danger going forward.
Lack of adequate diversification, exclusive and excessive exposure to market risk only, and exposure to structurally flawed asset exposures has cost investors dearly in recent years.
Yet this is exactly what many passive funds and portfolio approaches actually offer.
I am not suggesting that passive funds cannot be a valuable component of portfolios – we certainly use them in our own multi-asset portfolios.
Further, using largely passive funds and/or exchange traded funds for a dynamic asset allocation component of portfolios could also make sense for those in a position to implement this.
However, it is the largely static asset allocation of an all passive fund approach that blindly ignores the broader investment opportunity set which I believe is most vulnerable to disappointing both the risk and return expectations of clients – particularly if the current difficult investment environment continues.
Passive solutions are almost certainly better than haphazardly put together portfolios picked from elongated approved product lists dominated by products that are currently ‘hot’, or those promoted most aggressively by fund managers.
But passive funds’ so called ‘low risk’ characteristics, as well as their ‘low cost’ benefits, have been heavily oversold in recent times – from both an investment and business perspective – particularly compared to intelligently diversified and well managed portfolios selected from a more complete investment universe.
Unfortunately, the active management industry has recently done a terrible job of making its case and defending against this passive onslaught. It’s time to get a more balanced debate going.
Dominic McCormick is the chief investment officer of Select Asset Management.
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