The perils of passive investment
Huge swathes of investor capital has been allocated to passive investment strategies over the past decade. Investors have feasted on the abundance of liquidity provided by central banks and continual desire for products with lower fees.
In fact, according to JP Morgan, ETFs now account for 24% of all trading volumes in the United States. ‘Non-human’ or ‘non-discretionary’ investors now drives 90% of trading volume. These include High-Frequency traders, ETFs, trackers, algorithmic trading strategies, rules-based quant, etc. But why does this obsession with ETFs matter?
Performance for one hasn’t been as strong as you may imagine, particularly when you compare traditional investment funds with ETFs. The founder of Vanguard, Jack Bogle, recently shared his analysis of dollar-weighted investor returns with the investment magazine Barron’s. It showed that from 2005 to 2017, the average investor return from “Traditional Index Funds” was 8.4%. Whereas for ETFs, it was 5.5%. If ETF performance is so much worse than Traditional Index Funds then one might ask – “what is the point”?
One of the fundamental issues for investors is that passive investment is indiscriminate. As such, there is no price discovery mechanism relating to the underlying equity. The advent of products such as Smart Beta ETFs allows investors to invest in a specific sector or style. This means that when markets are going up, then money flows freely into assets that are trading at expensive multiples. When markets are correct, investors (often retail) withdraw their money and sell at the bottom creating a cascade effect. This means that looking forwards bubbles could be bigger and troughs could be deeper, at least temporarily.
The liquidity lobster trap
Another issue that we have warned about is the liquidity mismatch that impacts investors in the event of a market stress event. Firstly, ETFs vehicles are priced and traded continuously, yet invest in assets 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. History has shown us that liquidity in the fixed income space, in particular, can dry up (as witnessed during the Global Financial Crisis). Particularly non-standard investments such as emerging market debt. Secondly, investors holding synthetic ETFs may find that the return profile of the ETF is somewhat different from the underlying index.
As central banks begin to batten down the hatches and embark on part two of the money experiment (Quantitative Tightening), we expect to see an increase in volatility. 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.