It seems impossible to believe that 25 years ago, passive investing was considered a niche investment strategy. Only around 15% of fund assets were allocated to passive funds, including the household name UK tracker fund that charged an eye-watering 1%.
In 2000, David Swensen, Yale University’s CIO wrote his brilliant book on investing for endowments, including allocating to highly active strategies such as hedge funds and private equity. This quote stuck with me when I read it at the time:
“Ironically, those investors smart enough to recognise that passive strategies represent the best choice are often smart enough to mistakenly believe that they also possess the skills necessary to outperform market averages.”
Of course, he too believed he was smart enough to do better than index returns, and he was right, at least in the decade that followed.
Many now believe that investing in anything other than market cap index funds is not smart, but dumb
The pendulum has swung a long way since then. Many now believe that investing in anything other than market cap index funds is not smart, but dumb, and that the evidence shows that market cap always wins.
We are strong believers in the power of passive investing to efficiently capture market beta, but it’s important to recognise that risks within a passive fund are not constant: what may start off as a broadly diversified index can become extremely concentrated.
For example, a global tracker fund in 1989 had Japan as by far the biggest country at around 45%, before Japanese equities fell by a cool 60% over the next four years. No wonder global funds fell out of favour and country funds became all the rage in the 1990s.
Of course, concentrating into winners is a successful strategy (ask Elon Musk) but also a risky one (just ask the people you’ve never heard of). Just be sure to keep on backing the winners.
Today, many portfolios with thousands of underlying securities have fewer drivers of return than ever
The uncomfortable truth is that today, many portfolios with thousands of underlying securities have fewer drivers of return than ever. For equities, the concentration of the US stock market – now almost three-quarters of developed market indices – is at an extreme rarely seen in stock market history.
We have a precedent: the 2000s. During this decade, when markets began just as concentrated, with large pockets of overvaluation. A market cap weighted fund delivered zero returns for investors with two cruel bear markets to endure.
Diversification really worked: an equally weighted world index fund outperformed by nearly 70%; investors that diversified into emerging markets outperformed by 160%.
Of course, those lessons have been forgotten by many. Or maybe it has been beaten out of them: in the last decade, being underweight some of the largest US stocks has meant missing some of the best returns available.
Three ways to add diversification to your global allocation
But over 25 years, an equal weight portfolio of 1300 global stocks has beaten its market cap cousin, with fewer heart-in-mouth moments along the way.
Diversification works. It reduces risks and can help compound at a higher rate, just not all the time. And today, it’s possible to track regions, factors, sectors and themes in passive portfolios, as well as utilising tactical asset allocation to generate alpha and reduce risk.
While market cap weighted equities appear unbeatable to some, index weighted bond tracker funds have lost many from their fan club. Here too, investors need to be mindful of the huge, but more subtle changes under the surface.
Over the last 25 years, tracker funds of UK government bonds have seen risks shift markedly, while continuing to dutifully track the gilt index. In early 2000, the duration was 7.4 years and yields averaged 5.6%. Unfortunately, the mathematics of bonds means that as future returns (yields) fall, sensitivity to rates (duration) rises.
Passive investing has materially lowered the cost of investing for individuals and professionals alike
So, by the summer 2020, interest rate sensitivity had almost doubled, while the ten-year gilt yield had fallen to 0.07%. Next stop a 35% drawdown.
Passive investing has materially lowered the cost of investing for individuals and professionals alike. We have long maintained that the battle between active and passive ignores the best that each can offer; that’s why we run blended portfolios.
It’s vital to understand the risks in any index, rather than blithely assuming it always wins. And for pure passive investors, there is much more to life than just market cap investing.
Will Bartleet is CIO of Pacific Asset Management
