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Passive funds will feel the most pain when markets turn down

21122017 ETFs

Passive funds will feel the most pain when markets turn down

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.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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12 Comments

  1. Desmond Phillipson
    :

    Surely listed ETF’s don’t need to sell underlying stocks in the event of a market downturn. Unitholders simply sell on the market.

    • Hi Des,

      They have to sell down portfolio, in proportion to your selling, for you to have your money returned to you. These are not LIC’s (Listed Investment Companies), which are closed ended – and where the seller of shares is reliant on a buyer of the same shares to exit. ETF’s issue units and redeem units. In other words they are open-ended and can grow and shrink in size. If everyone wanted out, the manager (Fidelity, Vanguard et al) would have to sell the entire portfolio (less any amount they might have seeded the fund with themselves).

  2. Hi Roger
    Does this mean the ‘The Montgomery Global Equities Fund (Managed Fund)’ will be hit hard too as I thought this is an ETF?

  3. Passive investing could very well be contributing to a market inefficiency. This could give opportunities to intelligent active investors such as yourself Roger. However, there have also been modern improvements in market efficiency with easy access to financials, news, analyst information and investment books. For a long-term buy and hold investor, tracking the market with an ETF should be safe, unless we agree that valuations are too high to invest in equities (which is a fair argument). Ultimately, unless we can time the market, no-one will be safe from this inevitable crash – not even Warren Buffett.

  4. I think passive funds generally do better in a downturn.
    for instance – If you have an ASX200/300 index nearly a third of that is in the banks, they are at already low PE ratios so wont and cant drop too much more, and they pay healthy franked dividends. If the CBA price drops 6% next year, you’d still break even after dividends.

    However If you hand pick some small caps – many dont make a profit, some trading at high PE and PB ratios they will be crushed in a downturn. They wont pay dividends either.

    Overall more active than passive investors will come unstuck in the next correction.

      • Or maybe the past, my father bought CBA in 2009 for $25 after it fell from about $60 in 07 and now its exposed to a massive Asset bubble being probably the most expensive property market/casino in the world, Dad sold out of CBA a few months ago. But I’d say he’ll be back in after the Big Bang.

  5. Hi Roger

    Valuations for the ASX 200/300 stocks are currently above the historical PE range, but not overly so – valuations appear to be more of a problem for the S & P 500.

    I tend to think that the catalyst for a correction will be rising interest rates. In America those rate rises are almost a certainty in 2018, but Australian interest rate rises will be more influenced by local inflation which is currently benign, although the cost of overseas ( US ) borrowings will rise and may affect us more than we expect. When America sneezes we catch a cold, so what happens there cannot be avoided here. Volatility will rise but that offers opportunities to acquire stocks at more attractive valuations – 2018 will be a market for the active investor/manager and less so for the passive investor/manager.

    In the article above Bank of America said – “the actual shares available, or true float for S&P 500 stocks, may be grossly overestimated.” What exactly are they saying ?

    Look forward to more of your articles in 2018 and all the best to you and your team for the coming festive season – Your recent Christmas message was very thought provoking and appropriate – we all tend to get carried away at this time of the year and overlook the fact that “Christ” is what ” Christmas” is all about.

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