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Is Passive Investing Already Passé?

January 25, 2023 By Jeremy Jones, CFA

By Dilok Klaisataporn @ Shutterstock.com

In the Financial Times, Mohamed El-Erian suggests that for now at least, passive investing’s time in the sun is over. He writes:

Should the vehicles that investors choose to place their money be a function of the investing environment? This question is not asked often enough by investment committees, which tend to focus on asset allocation issues, model portfolios and manager selection.

Yet it is a question that has become a lot more important for generating high risk-adjusted returns, particularly given the massive shift of money from active to passive investment strategies in recent years.

A simplified illustration of why this is the case comes from my student days. Armed with a Eurail-type pass, I travelled the European continent and, like many others, took advantage of the fixed menu offered by restaurants. They were diversified, low priced and did not require much local knowledge to choose from a long list of dishes. In short, it was a good way to fill my stomach and keep expenses down.

I suspect that I would have behaved differently had the digestion-related risks of these menus been greater and more variable. In such a world, I would have placed much greater importance on menu differentiation; and I would have equipped myself with a better understanding of local ingredients and dishes. More active management of my meals would have become a priority, including a more educated approach to individual menu selection.

Having opted in mass for the fixed-menu approach, investors now need to pay more attention to individual security selection given ongoing shifts in the investing environment.

Passive portfolio management is particularly attractive in a world where investment outcomes are heavily influenced by a common global factor. This was the case for more than a decade as the combination of artificially floored interest rates and massive injections of central bank liquidity boosted virtually all assets. Even zombie companies and fragile sovereigns could refinance without much difficulty or internal reforms.

Positive correlations within and across asset classes rose to unusually high levels. The generation of high returns and lower volatility did not seem to require a lot of individual investment selection, making passive approaches much more attractive, especially given their lower fees relative to active management.

The resulting large-scale demand shift to passive investing generated two supply-side reactions. First, more asset managers entered the space, increasing price competition and dramatically driving down fees. Second, some managers extended the offering of index-based passive approaches to much less liquid and higher risk segments of markets that are more subject to dislocations and default risk.

This common global factor was first shaken and now dislodged by rises in inflation that have required central banks to hike rates and reverse injections of liquidity into the economy. The outlook for investors is further complicated by growth risks as the three most systemically important economic areas globally — the US, Europe and China — have slowed, albeit for different reasons. In addition, the investment world is being impacted by major structural shifts including disruptive technological innovation, geopolitical tension, a reordering of supply chains and strains to social fabrics.

Read more here.

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Jeremy Jones, CFA
Jeremy Jones, CFA, CFP® is the Director of Research at Young Research & Publishing Inc., and the Chief Investment Officer at Richard C. Young & Co., Ltd. CNBC has ranked Richard C. Young & Co., Ltd. as one of the Top 100 Financial Advisors in the nation (2019-2022) Disclosure. Jeremy is also a contributing editor of youngresearch.com.
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