Did not think so, nor would I. However, investors that redeemed $250 billion from active funds and invested $1.3 trillion of assets into passive products as at August 2016 have implicitly agreed to that performance outcome in the event of an equity market correction.

And why wouldn’t they? As we are constantly reminded by the passive fund providers’ marketing teams, passive equity index funds have done very well these past few years whereas many actively managed investment processes have underperformed the major averages.

Much of the research that is published focuses on cost or relative performance of passive investments with very little focus on the main deficiency in passive investment strategies that is its lack of risk management.

Passive strategies by matching an index do not include plans to preserve investors’ capital by cutting investments that are not working. Or provide protection from giant market crashes. Risk remains undefined.

Many of the arguments in support of passive equity management are based on the view that security prices generally reflect all available information and that market-cap weighted portfolios are risk/return efficient.  As a result, the view is that it is not possible for an actively managed investment process to beat the index consistently therefore investors would be better off to “buy and hold” an index.

However, there is sufficient evidence showing that from time to time security prices become significantly mispriced relative to their intrinsic values. This results in inefficiencies in market capitalisation weighted indices. The mispricing in security prices can occur when the market under or over reacts to news or due to the irrational behaviours of investors.

Market capitalisation weighted passive strategies follow clearly defined portfolio construction rules regardless of any mispricing which is being reflected in stock prices. Naturally they will be overweight to overvalued stocks and sectors and vice versa. Here are two examples of this.

Firstly, in the technology bubble in the late 1990s and its subsequent collapse. As the market bubble developed it amplified the riskiness of these passive strategies due to the increased exposure to overvalued stocks and reduced exposure to undervalued stocks. In this case, the risk inherent in the index portfolio reached extreme levels of risk. The investment loss when the market corrected was exacerbated for funds with positive cash flows (like most passive funds recently) because new investments were bought at increasingly inflated prices.

As a second example, the global financial crisis of 2008 and 2009 was a case in point. When market volatility increased it resulted in a sharp increase in the correlation of stock returns. This is because investors sell the whole market, or a sector, without discrimination as their liquidity preference had increased. Passive funds included as they needed to sell stock to fund investor redemptions. This resulted in significant falls in equity indexes globally and significant losses for passive investors.

There is no need for an active investor to tough out volatile and dangerous market situations like a passive investor. They can choose to sit on the sidelines and wait for a better opportunity to invest.

Following such events, as market volatility subsides, many stock prices trade at significant discounts (or premiums) to their intrinsic value. This can be attributed to the irrational behaviour of market participants, leading to large deviation of market prices from their intrinsic values.

Many investors who were sitting in a passive strategy during the GFC, despite wearing the pain on the way down, also missed out on the significant returns that presented themselves in the subsequent rebound.

History has shown that when market volatility and dispersion of stock returns increases, actively managed strategies have the opportunity add significant value due to the greater availability of investment opportunities.

While not all market conditions provide clear investment opportunities, certain market periods and phases of the business cycle are beneficial for an actively managed investment strategy. Investors can identify and exploit mispriced opportunities during these times such these.

Before I get inundated with research proving one strategy over another this note is not meant to be a defence of index hugging “active” portfolio managers. More a reminder that passive investors need to be mindful that they are exposed to the risks that accumulates within the indexes.

Investing can never be a case of just “set and forget” and risk always needs to be managed carefully and actively.

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