Research

Menu

Back

Choose Language

July 31, 2023

News

The dangers of passive investing in choppier waters

Over the past decade, there has been a pronounced shift away from actively managed funds to passive strategies. While we do believe that both types of strategy have a role to play in portfolios, these roles must be continuously re-evaluated, especially today, as we undergo a sea change in the investment landscape.

As of late, heightened inflation has compelled major central banks to embark on some of the most aggressive rate hiking cycles on record, credit standards have tightened quite dramatically, and the cost of credit has shot up. All this puts economic growth in jeopardy and marks quite a change from the days of easy monetary policy and abundant central bank liquidity that some say led to an “everything bubble” and allowed even zombie firms to refinance themselves without a lot of difficulty.

In such a context, we believe that focusing too much on passive and not enough on active could be risky.

Here’s why:

  1. Passive investors buy the whole haystack

In essence, passive investing involves buying the whole haystack instead of spending time and resources searching for the needle. Normally, when an index fund or ETF receives inflows, it will invest in assets based on their index allocation at that moment in time, without other considerations beyond their index construction rules.

Having a mixed bag of companies can be ok when times are good. But today, tighter financial conditions and slowing growth in the world’s major economies are starting to expose vulnerabilities, calling for greater discernment in separating the wheat from the chaff.

  1. Passive strategies are relatively rigid

Passive vehicles do not adjust exposure if they perceive certain sectors or companies look poised to underperform, they earn whatever the market earns based on the benchmark. This can lead to governance issues and brewing storms might go under the radar until it is too late.

By going through a company’s financial statements with a fine toothcomb, active managers can construct a more nuanced allocation aimed at maximising upside potential while minimising downside risk. Currently, that might mean screening for companies with enough financial firepower to weather any incoming storm or for companies that managed to lock in low rates before the spike in credit costs… Active managers are also better placed to sidestep “problem segments” of the market which today might mean trimming holdings of firms exposed to commercial real estate. Index funds do not have the same agility to avoid proverbial wasp nests.

In a sign of the times, this year, iShares converted its $707mn MSCI Frontier and Select EM ETF to active management to “allow greater flexibility and liquidity in various market conditions”.

  1. Risks can be overlooked or underestimated

Linked to the above, is the fact that investors might not always understand the intricacies within the passive funds they are holding. Amid heightened demand in the last decade, passive strategies now also track murkier areas of the market that are more vulnerable to dislocations or default risk, and which were traditionally considered an experts’ domain.

Before the banking crisis, CoCos had become a popular asset class, offering relatively high yields and many investors chose to play this trade via passive index funds. Prior to the Credit Suisse default, an index fund tracking iBoxx Contingent Convertible Liquid Developed Europe AT1 Index, would have had around 5.4% of its assets invested in Credit Suisse CoCos, a position that was all but wiped out after the rescue, much to the surprise of some investors.

An active fund would have had more flexibility to hold a lower (or no) position in Credit Suisse and thus, avoid this loss of capital. A passive debt fund will, by default, have the biggest positions in the company which issues the most debt.

  1. Passive investment strategies are not immune to market risk

Passive investing means being exposed to a broad index and as such, performance will largely be dictated by market fluctuations. In a context where markets face more snakes than ladders, for example, during a recession, investments will most likely be negatively impacted. Note that the probability of a recession in the next 12 months is 65% in the US, and 50% in the Eurozone, according to  Bloomberg consensus estimates.

  1. What happens during a selloff?

Because passive investing can encourage crowding into specific corners of the market, a large risk factor is what happens if an unforeseen shock made investors want to jump ship all at once. It would be very difficult for the market to take the weight of all that selling, and liquidity could dry up for the product itself and for the underlying holdings. In such a scenario, bid-ask spreads could spike, meaning that investors might have to incur huge losses to exit their passive positions.

Conclusion

Over the past decade, positive correlations within and across asset classes rose to unusually high levels. Achieving good returns did not seem to require a lot of effort, and passive approached flourished, especially given ultra-low fees. However, given that the tide of liquidity that lifted all boats is now subsiding, investors need to confirm whether the passive vehicles they are invested in are still seaworthy.

In favour of active management, choppy waters could bring back a dispersion of returns – something that professional managers need to demonstrate their skill. In volatile and uncertain times, the name of the game is not just alpha generation, but also risk management. For this, accurate fundamental analysis is crucial.

Disclaimer

All financial data and/or economic information released by this Publication (the “Publication”); (the “Data” or the “Financial data and/or economic information”), are provided for information purposes only, without warranty of any kind, including without limitation the warranties of merchantability, fitness for a particular purpose or warranties and non-infringement of any patent, intellectual property or proprietary rights of any party, and are not intended for trading purposes. Banque Internationale à Luxembourg SA (the “Bank”) does not guarantee expressly or impliedly, the sequence, accuracy, adequacy, legality, completeness, reliability, usefulness or timeless of any Data. All Financial data and/or economic information provided may be delayed or may contain errors or be incomplete. This disclaimer applies to both isolated and aggregate uses of the Data. All Data is provided on an “as is” basis. None of the Financial data and/or economic information contained on this Publication constitutes a solicitation, offer, opinion, or recommendation, a guarantee of results, nor a solicitation by the Bank of an offer to buy or sell any security, products and services mentioned into it or to make investments. Moreover, none of the Financial data and/or economic information contained on this Publication provides legal, tax accounting, financial or investment advice or services regarding the profitability or suitability of any security or investment. This Publication has not been prepared with the aim to take an investor’s particular investment objectives, financial position or needs into account. It is up to the investor himself to consider whether the Data contained herein this Publication is appropriate to his needs, financial position and objectives or to seek professional independent advice before making an investment decision based upon the Data. No investment decision whatsoever may result from solely reading this document. In order to read and understand the Financial data and/or economic information included in this document, you will need to have knowledge and experience of financial markets. If this is not the case, please contact your relationship manager. This Publication is prepared by the Bank and is based on data available to the public and upon information from sources believed to be reliable and accurate, taken from stock exchanges and third parties. The Bank, including its parent,- subsidiary or affiliate entities, agents, directors, officers, employees, representatives or suppliers, shall not, directly or indirectly, be liable, in any way, for any: inaccuracies or errors in or omissions from the Financial data and/or economic information, including but not limited to financial data regardless of the cause of such or for any investment decision made, action taken, or action not taken of whatever nature in reliance upon any Data provided herein, nor for any loss or damage, direct or indirect, special or consequential, arising from any use of this Publication or of its content. This Publication is only valid at the moment of its editing, unless otherwise specified. All Financial data and/or economic information contained herein can also quickly become out-of- date. All Data is subject to change without notice and may not be incorporated in any new version of this Publication. The Bank has no obligation to update this Publication upon the availability of new data, the occurrence of new events and/or other evolutions. Before making an investment decision, the investor must read carefully the terms and conditions of the documentation relating to the specific products or services. Past performance is no guarantee of future performance. Products or services described in this Publication may not be available in all countries and may be subject to restrictions in some persons or in some countries. No part of this Publication may be reproduced, distributed, modified, linked to or used for any public or commercial purpose without the prior written consent of the Bank. In any case, all Financial data and/or economic information provided on this Publication are not intended for use by, or distribution to, any person or entity in any jurisdiction or country where such use or distribution would be contrary to law and/or regulation. If you have obtained this Publication from a source other than the Bank website, be aware that electronic documentation can be altered subsequent to original distribution.

As economic conditions are subject to change, the information and opinions presented in this outlook are current only as of the date indicated in the matrix or the publication date. This publication is based on data available to the public and upon information that is considered as reliable. Even if particular attention has been paid to its content, no guarantee, warranty or representation is given to the accuracy or completeness thereof. Banque Internationale à Luxembourg cannot be held liable or responsible with respect to the information expressed herein. This document has been prepared only for information purposes and does not constitute an offer or invitation to make investments. It is up to investors themselves to consider whether the information contained herein is appropriate to their needs and objectives or to seek advice before making an investment decision based upon this information. Banque Internationale à Luxembourg accepts no liability whatsoever for any investment decisions of whatever nature by the user of this publication, which are in any way based on this publication, nor for any loss or damage arising from any use of this publication or its content. This publication, prepared by Banque Internationale à Luxembourg (BIL), may not be copied or duplicated in any form whatsoever or redistributed without the prior written consent of BIL 69, route d’Esch ı L-2953 Luxembourg ı RCS Luxembourg B-6307 ı Tel. +352 4590 6699 ı www.bil.com.

Read more


More

November 25, 2024

Weekly Insights

Weekly Investment Insights

  After last week's disappointing Eurozone economic data, another ECB rate cut in December is high on the wish list for Europe, with investors increasing...

November 22, 2024

BILBoard

BILBoard December 2024 – Red Sweep

    At BIL, we are long-term investors guided by stable, strategic asset allocation guidelines. However, our investment strategy itself is a living, breathing thing,...

November 18, 2024

Weekly Insights

Weekly Investment Insights

  Less than two weeks after the US Presidential election, Trump has made significant progress in nominations for top government posts, leading to some market...

November 8, 2024

Weekly Insights

Weekly Investment Insights

  Last week, the result of the US Presidential election was finally announced, with Donald Trump elected as the President of the United States for...

November 7, 2024

News

The impact of the US election

    The results of the US presidential election have been made clear, with Donald Trump elected as the President of the United States for...

All articles