Passive funds will feel the most pain when markets turn down

By Roger Montgomery, Montgomery Investment Management

When markets are rising - as they are right now - it can make sense to passively invest in index funds. But when a downturn inevitably comes, passive funds will be hit the hardest. We're not the only commentator ringing the alarm bell. Warnings against passive strategies have been mounting throughout the year.

For example, earlier in 2017, Bank of America rang a warning bell regarding all the money piling into passive exchange-traded funds (ETFs), noting the massive popularity of ETFs was the precursor to a "liquidity problem". And that "the actual shares available, or true float for S&P 500 stocks, may be grossly overestimated."

And, just this week, David Wright - the managing partner of respected rating agency Zenith Investment Partners - said a market downturn would be especially damaging for passively managed portfolios.

We repeat their comments here.

"Because we've had such low volatility and for a long time now, there's a bit of investor apathy at the moment," Mr Wright said.

Many investors holding passive products are labouring under the impression that "this is actually quite easy", he said.

"When we do have more volatility and/or a downturn, that's going to be quite painful for a lot of people who have positioned passively," Mr Wright said.

"The markets are pretty precariously balanced if we have a left-field event. Most things are priced for perfection.

"People need to realise that the central bank intervention has really depressed volatility and that has led to a large part of the beta [passive] rally."

Mr Wright said it is hardly surprising that passive investment strategies are sitting at the top of performance tables, given that markets are at the end of an extended bull run.

Most active managers worth their salt will not be participating in markets when valuations are sky-high, he said.

Fortunately, most of the advice community has come to the realisation that most asset classes are "fully priced to expensive", he said - which has driven demand for alternative strategies over the past year.

"For the first time since the GFC, we've seen some genuine product issuance in alternatives. New global macro product, a couple of currency products and multi factor real return funds," Mr Wright said.

But he was not confident that investors - advised or not - are appropriately positioned to withstand the effects of another GFC.

"The problem you have with investment markets is that you have a different generation of investors [during each crisis]. So they can read about past corrections, but until you've been through [a correction] yourself you don't properly learn," Mr Wright said.

That said, it has been encouraging to see markets quickly bounce back after geopolitical shocks like Brexit, the Trump election and various terrorist attacks, he said.

"The ability to generate returns at the moment is relying a lot on relative value trades. So where a market corrects people have piled in and taken advantage of it," Mr Wright said.

"It's not that clear where a major catalyst for a correction in market is going to come from."

Zenith Investment Partners (ABN 60 103 132 672, AFS Licence 226872) is the provider of general advice. To the extent that any content of this document constitutes advice, it is General Advice (s766B Corporations Act 2001) for Wholesale clients only and has been prepared without taking into consideration the objectives, financial situation or needs of any specific person. Investors should seek their own independent financial advice and obtain a copy of, and consider, any relevant product PDS or offer document before making any investment decision. Any content in this document prepared by Zenith is subject to copyright and may not be reproduced without the consent of the copyright owner. It has been prepared in good faith and Zenith accepts no liability, whether direct or indirect, for any errors or omissions. Past performance is not an indication of future performance.

 
Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

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