Andy Peach, principal consultant at Aon
Equity markets have had it easy for 10 years.
Since the nadir of the financial crisis in 2009, investors have enjoyed strong equity returns – the MSCI World has grown by around 15% a year in local currency terms during the past 10 years.
With equity indices providing returns like that, it has been hard for active managers to demonstrate added value so it’s easy to see why passive investment has grown in popularity.
In the same period, global investment in passive equity management has grown by $2.3trn, while active investments have shrunk by $2.5trn, and these passive investors have been rewarded with “easy” money. We have now entered a transitional phase in global markets, from a period where risky assets have performed well to one where volatility is likely to remain elevated.
An Apple the size of Australia
Passive investing provides exposure to a great many stocks, but it is not necessarily true that passive investors enjoy great diversification. Market cap indices have high levels of stock concentration in the largest companies. For example, the top 10 holdings of the MSCI World (c.13% of the index) have the same weight as the smallest 877 stocks in the index.
The global market is just as dependent on a few companies as it is on entire nations with large economies. The index weighting of US tech firm Apple alone is the size of Australia. This is not necessarily a problem if you have consciously decided on this allocation but, by definition, most passive investors have not.
In Q4 2018, the MSCI World experienced its largest quarterly drawdown (-13%) in seven years. A sizeable portion of this, approximately one-sixth, can be attributed to the top 10 companies, which make up less than 1% of the number of stocks in the index.
Markets have clearly regained some composure in the first half of 2019, but volatility spiked again in May, with major US tech firms leading market losses. But there are likely to be further headwinds. This could well be the start of a sustained period of volatility from which passive investors have no place to hide.
Factor-based investing: a potential alternative
For investors looking to keep the benefits of passive investing (low cost, high liquidity, limited governance) then factor-based investing presents a compelling alternative.
Factor-based investing systematically allocates to stocks based on technical information and company fundamentals targeting specific drivers of return.
Evidence shows that, if properly constructed, it ought to add value over and above the market cap equivalent over the long term. Another benefit is that no single stock should dominate the index. Factor-based investing is not a silver bullet but, in potentially volatile times, it avoids taking large bets on individual companies, which may be an advantage.
If you are a passive investor, the chances are it has worked well in recent times. But now may be the right time to reconsider how you gain exposure to equity markets.
For more details, contact Andy Peach at firstname.lastname@example.org