The perils of passive investing

Huge swathes of investor capital have been allocated to passive strategies over the past decade as investors have feasted on the abundance of liquidity provided by central banks and the continual desire for products with lower fees.

We expect to see an increase in volatility in markets and as such, we believe that it is prudent to invest in active managers and at the very least, hold assets that you understand and have ample liquidity.

In fact, according to reports by JP Morgan1 and Bank of America Merrill Lynch2, Exchange Traded Funds (ETFs) now account for circa 25% of all trading volumes in the United States, and around 90% of trading volume is now driven by 'non-human' or 'non-discretionary' investors. Examples include High Frequency traders, ETFs, trackers, algorithmic trading strategies, rules-based quant, and so on. In other words, only 10% of trading volumes actually originate from discretionary trades by investors. But why does this obsession with ETFs matter?

Well, performance for one hasn't been as strong as you may imagine, particularly when you compare Traditional Index Funds (TIFs) with ETFs. The founder of Vanguard, Jack Bogle, recently shared his analysis of dollar-weighted investor returns with the investment magazine Barron's3. The research shows that from 2005 to 2017, the average investor return from TIFs was 8.4%, whereas for ETFs, it was 5.5%. If ETF performance is so much worse than TIFs then one might ask – "what is the point?"

Volatility exacerbated

The marginal buyer or seller drives the price of a good and, in this case, a share price or index level. As a consequence, one of the fundamental issues for investors is that passive investing is indiscriminate; there is no price discovery mechanism relating to the underlying equity. Participants not driven by the analysis of fundamental factors are therefore responsible for share price levels. The advent of products such as Smart Beta ETFs that allow investors to invest in a specific sector or style means that when markets are going up, money flows freely into crowded assets that are trading at expensive multiples. Then when markets subsequently correct, investors (often retail) withdraw their money and sell at the bottom, creating a cascade effect. The effect of this ever-growing wall of passive money could mean that future bubbles could be bigger, and troughs could be deeper, at least temporarily.

Since 2008, yield compression in conventional low risk income assets such as Gilts, Treasuries and Cash has forced investors into higher risk or income producing strategies such as selling Chicago Board Option Exchange (CBOE) Volatility Index (VIX) options or buying inverse VIX ETFs. Selling VIX options to generate income or yield has been compared to picking up stones in front of a steam train. We only need to look at the VIX blow up from February this year where many investors lost the total value of their short volatility position in a matter of hours. This kind of occurrence is a cautionary tale of the risks of investing in complex levered products.

The "liquidity lobster trap"

Another issue that we are wary of is the liquidity mismatch that could impact investors in the event of a market stress event. Firstly, ETFs are vehicles that are priced and trade continuously, yet invest in assets that often cannot provide daily liquidity. Investing in assets with poor liquidity can be like a "lobster trap"; very easy to get into but impossible to get out when you need to escape. History has shown us that liquidity, in the fixed income space in particular, can dry up (as witnessed during the Global Financial Crisis), and most commonly for sectors with the lowest levels of liquidity such as emerging market debt and High Yield.

Another issue that investors may encounter is that investors holding synthetic ETFs (ETFs that rely on derivatives such as swaps to execute its investment strategy instead of physically owning the stock) may find that the return profile of their ETF is somewhat different to the underlying index, due to either replication or composition or other market factors. Daily rebalancing and compounding on a leveraged ETF could result in a negative return, despite the fact that the underlying index is up over the investment horizon. This happened in 2008 for many investors who were short the market.

Finally, investors in synthetic ETFs expose themselves to the risk that one of the derivative counterparties defaults. Synthetic ETFs are popular because they frequently have a lower tracking error and are sometimes cheaper than physically replicated ETFs. However, it is not uncommon for individuals to underestimate, or even misunderstand, this counterparty and collateralisation risk, ultimately resulting in the potential loss of all the initial investment.

It's not hard to understand why ETFs and passive products have been so popular since 2009, particularly as markets have continued to push higher through a combination of share buybacks, multiple expansion and for the large part, low volatility. However, betting on a repeat of the last nine years is a bet that we are unwilling to make, particularly as central banks begin to batten down the hatches and embark on part two of the most extraordinary money experiment in history (transitioning from Quantitative Easing to Quantitative Tightening). The taper tantrum of 2013 demonstrated the difficult task that Central Banks have in taking liquidity out of the system.

Looking forward, we expect to see an increase in volatility in markets and as such, we believe that it is prudent to invest in active managers and at the very least, hold assets that you understand and have ample liquidity.

Consequently, in the LGT Vestra MPS portfolios, we only hold funds that we have researched, and we try to avoid investments that may encounter liquidity issues. It is for this reason that we sold our exposure to open-ended property vehicles in 2016 prior to the Brexit referendum and it is also why we are cognisant of the risks posed by holding funds that have an elevated percentage of unlisted assets. Holding that jazzy 3X Levered Smart Beta ETF might be popular with clients but when the market drops 20% it may not look quite so impressive after all.

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  2. Equity & Strategy Focus Point: The ETF-ization of the S&P 500, Bank of America Merrill Lynch, 2017

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