As published on Family Wealth Report
The age-old debate about the pros and cons of “active” versus “passive” investing got a new jolt when global equity markets slumped earlier this year – and then recovered somewhat on the back of massive central bank quantitative easing. (We will see how long this recovery might last, given some grim economic data.)
The problem with these terms, of course, is that they can be misleading. Even the most “passive” investor is taking a decision of some kind, if only to capture market “Beta” rather than try and be cleverer than the other guy by picking undervalued stocks or predicting if a security is going to fall before others do. “Passive” entities such as exchange traded funds can be used to build portfolios where an active strategy is involved. We have had the phenomenon of “Smart Beta”, aka factor-based investing, and so forth.
The conversation goes on because, at root, this is about the added-value proposition of investment management. And it speaks to how wealth management is also about deciding how to handle risk, given that no-one is omniscient, has perfect information about what drives markets, or will be able to reliably time markets. Add in, of course, the commercial vested interests driving what sort of funds are pushed in front of advisors and clients, and it is easy to see why debate rolls on.
To discuss some of these ideas are Jeanette Garretty, chief economist and Stuart Katz, chief investment officer, at Robertson Stephens Wealth Management. The editors here are pleased to share these ideas; the usual disclaimers apply. Jump into the debate and email firstname.lastname@example.org or email@example.com
No question about investing is likely to lead to fisticuffs faster than the question of the relative merits of active and passive investments. It is not without reason that the debate has taken on the fervor of religious arguments, as people have come to think of themselves as having innate qualities as active or passive investors. Lost in the conflict is a focus on the actual reason why there are both active and passive investments, and why, at different times and for different purposes, both types of investments make sense. In general, when companies are operating in a stable, well-understood economic environment and company financial information is widely accessible, an active manager may not add much in the way of differential (positive) performance. It is for this reason that there are a number of widely utilized passive investments for US large cap stocks. However, for investments in industries or sectors defined by innovation and disruption and lack of transparency – technology, healthcare, small cap, emerging markets, non-investment grade credit, to name a few – an active manager may be the best way to find opportunities and pursue investment themes such as digital infrastructure.
Furthermore, an active manager implements bottom up fundamental research and judgement to select and weight quality business models at attractive valuations. This contrasts with passive funds that employ “top down” formulas. This flexibility can lead to a fund that over time demonstrates significant “downside capture”, i.e. capturing less of the downturn in the overall market when times are bad while obtaining most of the upside of rising markets. Therefore, active management can be an important part of the defense for a portfolio, even though invested in so-called risk assets such as equities.
The challenge, of course, is in deploying active and passive investments effectively to achieve the overarching goal of the financial plan. Portfolio construction without a plan is similar to getting into a car without knowing your destination. A careful evaluation of any manager, includes strategy, process, fees, and tax efficiency, with passive investments requiring special attention to the sometimes minute but important differences in composition and leverage that can easily be overlooked. The lack of experience, skills, process and time to focus on active manager selection often leads to a default passive only solution.
Today – May 2020 – no one would describe the economic environment as “stable and well-understood.” It seems that each week, we witness another unprecedented development including most recently employers cutting a monthly record 20.5 million jobs in April and joblessness standing at 14.7 per cent, the worse level since the Great Depression. As we begin to think of opening up the economy, we begin to absorb that the recovery, like all recoveries, will be distinguished by its wide variety of winners and losers – with the added appreciation that being a “loser” in this recovery may mean going away, not just falling behind. Companies with strong balance sheets and management teams and exceptional products before the ravages of the pandemic will be the better prepared to survive and thrive. Unlike the expansion that inevitably follows, a recovery is not a wave to be surfed, a tide lifting all boats. A recovery is a hair-raising whitewater excursion, with Class 4 rapids. The right guide, the one who knows the river inside-and-out, is a treasure.
Having a fundamental view is critical, because economies, asset classes, industries, companies, and securities are experiencing unprecedented cross currents. Identifying the required margin of safety to protect and grow a client’s investment portfolio requires acumen and discipline in an environment where long-term growth and attractive income will be difficult to achieve. Currently, equity and credit markets seem to be anticipating different recovery timelines although there is often cross contamination of fear and greed between these markets creating dramatic and unpredictable levels of volatility. Volatility is an opportunity for investors with thoughtfully constructed portfolios.
The S&P 500 is approximately 15 per cent below its all-time high. However, there is approximately $250 billion US high yield bonds trading at less than 70 per cent of the amount they originally borrowed from investors. Corporate default rates are rising from 2 per cent over the last twelve months ending December 2020 and are now approximately 4-5 per cent. In excess of 30 per cent of US levered loans (typically, secured debt which is senior in a company’s capital structure) have been downgraded vs. their previous peak of 24 per cent at 2009. The current pressures on the US and global economy are also impacting municipalities and local governments who will face meaningfully lower revenues. As a result, investors need active managers who have experience of dealing with these challenges rather than passive funds which will not make the distinction between the relative winners and losers in terms of real estate or housing related securities which are more at-risk than essential service bonds.
Many investors are tempted now to passively invest in small capitalization stocks with the Russell 2000 Index (R2K) YTD performance down more than 2 times the S&P 500. However, relative price performance is only one of many necessary considerations and in fact may be the least important. We recommend that investors also focus on other key metrics including sector weights, profitability potential, valuation and financial health. Small-cap equities are underweight technology relative to the S&P 500 and are instead meaningfully exposed to cyclical sectors like financials, energy and REITs. Small cap earnings quality is generally speaking much lower than larger cap stocks where approximately 40 per cent of the R2000 has negative earnings. Consensus earnings forecasts anticipate a contraction in earnings putting upward pressure on small cap valuations which are already expensive relative to its history and larger cap peers.
Finally, the small cap index is highly leveraged with an average Net Debt/EBITDA ratio of about 3 times the size of companies in the S&P 500. Looking forward, we anticipate elevated uncertainty and this suggests the most prudent course of action is investing with proven active managers. Investors must remain patient and there are substantial opportunities today in small cap equities but a passive approach to invest in the good, bad and ugly is unwise.
These are only a handful of examples to support the need for actively managed strategies where they can broaden the opportunity set available to investors, mitigate risk and drive notable investment outcomes over longer time horizons by enabling investors to participate more fully in the market upside and help to mitigate sharing in all the downside. In sum, a rigorous manager selection process that combines quantitative analysis and judgement matters and helps to drive results.
Ultimately, there will be greater clarity than we have at present with respect to the impact of the unprecedented monetary and fiscal stimulus plans to bridge the global economy to the other side of this health crisis. Many investors are hopeful, that these policies will be broad enough to raise entire industries and support passive sector investments. We recommend that – rather than passively relying on hope – investors actively choose advisors with an investment office that has intense focus, process and patience to persevere and guide portfolios over the long term.
Finally, a reminder: the very act of constructing investment portfolio solutions includes prudent asset allocation and rigorous manager selection which is an act of active management. Recognizing that the essence of portfolio management is the activity of paying attention is the first step in accepting that the correct answer to the question of “Are you an active or passive investor?” is “Yes”.