There have been vast amounts of studies done on the benefits or otherwise of passive investing with most concluding that, on average, active investors do not outperform the index and thus, after fees, will actually cost you money. Ergo, just buy passive. This is very appealing to the fiduciaries who manage the vast bulk of the world’s pension funds, insurance companies and endowments, as buying the benchmark means never having to say sorry. It’s the perfect job preservation scheme for them, but that is not the same as being the perfect savings and investment scheme for the underlying client.
Life can only be understood looking backwards, but must be lived forwards
Soren Kierkegaard
At the heart of the system is the fact that the returns you get are a function of the risks you take. If you take the same risk as the benchmark, by and large you should expect the same return, so by constraining active investors to take limited risk vis a vis the benchmark, with measures such as tracking error and volatility, you are effectively begging the question of outperformance. But what if you are uncomfortable with taking that level of risk? Sometimes you might want to take more risk and, more often than not thanks to the behavioural trait of loss aversion, you sometimes you might want to take less. Active managers thus have a further level of uncertainty to allow for, uncertainty which, as the philosopher Kierkegaard effectively points out, may disappear with hindsight, but is very real at the time.
It is also worth pointing out that the system itself puts an implicit constraint on the institutional active manager similar to that faced by the pension fund or endowment trustee; outperform and people are pleased, but you won’t get rewarded that much, (unless you are a hedge fund). Underperform and you are liable to be fired. We have thus strayed into the area where the risk being managed is the career risk of the insider, rather than the investment risk of the client.
Portfolio Construction is really about risk management
The problem for active investors is then, that usually they are not only required to be focussed on volatility and benchmark risk, as the passive and semi passive managers are, but also at least to some extent on the risk of the loss of capital - and thus the need to apologise. As a result, they are constantly trying to create portfolios with less downside risk than the market at the same time as having more upside potential. This is far from easy (!) especially as external allocators have a tendency to momentum - taking capital from the under-performer, perhaps one who saw risks as too high and giving it to the outperformer who either saw them as too low, or didn’t see them (or need to see them) at all.
Not only does this create its own issues of the cautious active investor being forced to redeem his value stocks while the more risk-taking momentum investor (including by definition passive) chases into more and more risky single stocks (think Julian Robertson of Tiger at the height of the Dot Com bubble) and thus exaggerates the bifurcation in the market, but it also penalises sensible risk management - if by risk we are to include loss of capital.
Looking backwards we can understand what happened as the uncertainty has gone - in this case that the risk of loss was either higher or lower than the active manager expected. However, because the active manager has to live forward and allow for uncertainty, by requiring them to look at risk from the underlying investors’ perspective, while not requiring the index tracker to do the same, we are creating a false paradigm.
Currently, we see allocators chasing US Tech funds that did extremely well last year, not least down to the crowding effect of $3 out of every $10 going into a passive index of 500 stocks actually going into the 10 largest ones based on no other factor than their existing market cap. At a sector level, a tech ETF will likely be benchmarked against a market cap based index and thus will similarly be making no fundamental assessment, nor of course will the allocators switching out of, say, Energy funds or ETFs into the Tech equivalent. An active manager trying to construct a portfolio to take less risk on the downside and more risk on the upside thus has to also take account of forced buying and distressed selling by these sub index trackers as part of the idiosyncratic stock risk - another level of risk the index tracker doesn’t need to manage.
Passive creates crowding - and more risks
There are other risks too, in fact ones created by the passive industry that have got larger as the passives have become more dominant. For example, indexation means that ‘low risk’ investors are increasingly crowded in to the biggest stocks or bonds, creating an unaccounted for, but nevertheless very real, level of concentration risk that brings with it liquidity risk - both of which matter for the active investor focusing on capital loss.
Nobody minds a crowded trade on the upside…
With equities it becomes a momentum effect as the bigger the market cap the more the index trackers and closet trackers have to own it, regardless of any fundamentals. Throw in smaller sub indices and themes dominated by one or two companies and there is further cross infection. Index trackers buying a benchmark which is even more concentrated than the S&P500 can thus have a disproportionate impact on the biggest stocks. And vice versa. Throw in technicals and Quants and the situation becomes even more exaggerated.
Of course, nobody minds a crowded trade and a lack of liquidity on the upside - mark to market gains are great for the manager and their fees. It’s the other side of the trade that causes the problems as the cascade effect of benchmark selling leads to the old expression of stocks going up the stairs and down the elevator shaft.
If your idea of risk in Credit markets is limited to benchmark risk, you are asking for trouble sooner or later
In Corporate bonds it can be even worse, for the weighting in the benchmark is usually a function of the amount of debt outstanding, which of itself becomes a risk factor. So the more debt issued, the riskier the issue can become and the more the ‘risk averse investor’ is forced into buying in order to avoid ‘benchmark risk’. Just when fundamentals are likely saying the opposite. For example, owning any, let alone a high percentage of, Chinese property developers’ debt would have been a poor decision from August 2021 onwards when Xi first announced a crackdown and yet ‘risk averse investors’ continued to buy due to the sector’s dominant position in the benchmark.
Bond investors generally have models that expect Equity holders to take most if not all of the loss and also make assumptions about asset backing and recovery. All very sensible, but less so when macro factors apply turning individual credit risk into a more systemic risk. Walter Writson of Citi Bank once famously said that ‘Countries don’t go bust’, shortly before most of the Latin American sovereign risk in Citi’s portfolios blew up. The same can be said of other, often highly correlated, sectors of the Credit markets. Like Chinese property developers.
To thus return to our China property example, the JP Morgan Asia Credit Index (JACI) had a weighting of 43% as recently as 2023 and so the risk averse high yield investors tracking the benchmark saw basically almost half of their holdings go to 7c on the $. Some risk management! The smart, or perhaps the slow, may have managed to get out in the speculative bounce in bonds like Evergrande and Country Garden, which rallied to 70c, before collapsing back to 7c but the wider point remains true. The ‘risk averse investors’ bought Credit with only a notional eye on the absolute return investment risk.
To Conclude:
So what does any of this mean? Far from being a lament for active managers, from our point of view it means that the closer the proposition gets to the actual investor and the greater the focus on absolute return and compound growth, the more appealing is the role of the active manager thinking about actual risk(s) rather than the synthetic ones of benchmark and volatility.
As such, we think that as active managers our time is best spent nearer to the underlying investor, where our role in managing actual risk is both accepted and acknowledged. Currently, the role of risk management at the wealth manger level is partially taken by the 60:40 fund, which acknowledges and accepts a lower level of risk and thus return than the straight equity benchmark indices. However, this too is largely a passive structure, where the asset allocation is largely determined by the size of the respective markets and the role of cash as a risk management tool has been overlooked in recent years.
We think it can be done better and there is a role for active management in the 60:40 space.. This will be the subject of an upcoming post.
