Momentum behind rising global equity markets and higher bond yields has begun to ebb as investors reduce their expectations for stronger growth and higher inflation. As a consequence, broad market direction is less likely to underpin investment performance in the second half of 2017. Accordingly, we believe it is important to augment portfolio performance via investment approaches that generate returns via security selection—i.e., using active management.
From mid-2016 until March of this year, advancing equity markets and rising bond yields were underpinned by better-than-expected economic data and expectations that reflationary US macroeconomic policy would boost nominal GDP. By the first quarter of this year, however, global growth expectations had peaked and were beginning to decline. The failure of the Republican Party to unite over healthcare reform in March then challenged the prevailing consensus regarding the likelihood of US tax reform and fiscal stimulus. Slowing Chinese credit growth took the wind out of the sails of most commodity markets. Lastly, surprising declines in headline and core inflation in the US and continental Europe have more recently raised doubts about the speed of monetary policy adjustment in the US and the eurozone.
In short, the underpinnings for further gains in so-called ‘reflation trades’, which had propelled multi-asset portfolio performance over the preceding three quarters, have come into question, reducing the contribution of market directionality (‘beta’). Given that so-called index-tracking ‘passive’ strategies derive their returns almost exclusively from trend participation, their performance has begun to lag as market momentum has stalled.
Accordingly, we believe it is appropriate to augment portfolio performance via actively managed positions. These include select exposure to emerging equities and to unhedged local currency emerging market fixed income securities. We also prefer subordinated debt of financials, off-the-run mortgaged back securities and multi-asset target return strategies, none of which are readily available via lower cost, ‘passive’ approaches.
To begin, we believe the term ‘passive investing’ is oft misunderstood and misused. A truly passive approach involves the selection of an instrument that allows the investor to replicate a relevant index, typically at low cost. In its original form, passive investing utilised exchanged traded funds (ETFs) that tracked the market-capitalisation weighted index of a particular asset class, such as equities or bonds.
We are not advocates of passive investing in the sense defined above. Partly, that is because we believe that markets are not always efficient, and hence offer opportunities to generate additional return over index tracking. We are also concerned that investing according to market capitalisation, irrespective of other factors, creates a misallocation of capital, both at the aggregate and individual levels.
However, in its more common (yet incorrect) usage, ‘passive’ investing often refers to the implementation of investment strategies using lower cost instruments, chiefly exchange-traded funds and futures, but not necessarily as a means to replicate market capitalisation. Insofar as such approaches typically embed clear active investment decision-making—for example, which low-cost instruments to use to position in which parts of capital markets—we prefer a different nomenclature. Rather than ‘passive’, these investment decisions can be dubbed low-cost active management, which more accurately describes the investment approach.
We are advocates of low-cost active management. We regularly use ETFs and futures when our view is that the best risk/reward outcome represents exposure to broad market trends (‘beta’). We also believe that market inefficiencies are less pronounced in large capitalisation markets, such as the S&P500. We will often therefore take exposure to the broad market via low-cost funds or futures, rather than via a fund of active managers. It also often makes sense to use ETFs to actively allocate between different styles (factor investing) or across sectors.
In short, we do not invest passively in the proper sense of the term. But we are proponents of using low cost instruments to execute active investment decisions.