How Resilient is Passive Investing?
by Kevin Dehod
The popularity of passive investments, such as exchange traded funds (ETFs) and index-tracking mutual funds are on the rise as investors have begun to rapidly shift their portfolio allocation away from active management. Investors are intrigued with passive investment strategies because of the perception that passive investing can outperform in all investment landscapes, lower fees, and that it's the latest and greatest trend being marketed as the best investment vehicle.
For the 12 months preceding February 2017, ETF assets in both the US and Canada hit new record highs. In the US, the ETF industry grew by 36% to USD 2.76 trillion in assets. In Canada, the ETF industry also grew by 36% to CAD 120.2 billion in assets. If used effectively and in the right asset classes, ETFs can, at times, be an efficient tool in the portfolio construction process. With industry growth fuelling an explosion of different strategies and products available, consensus has quickly grown among retail and institutional investors that this is the new and best way to invest, resulting in over-allocation to these investment vehicles. We believe whenever market participants start to develop a strong consensus, caution is in order. In the words of Warren Buffett, “you can’t buy what is popular and do well.”
Figure 1 shows the dramatic jump in the number of equity indices created for tracking purposes from 600 in 2012 to 4800 by the end of 2016. One of the fastest growing areas within the ETF universe is “smart beta” or “strategic beta” funds, which make up approximately 21% of all ETF assets in the US, and have grown over 465% in the last nine years. Smart beta strategies attempt to deliver a superior risk/reward trade off over conventional market cap weighted index ETFs by utilizing objective factors like dividend yield, volatility, and p/e ratio to construct a passive portfolio.
Our primary concern with some of the passive ETF strategies being promoted is the assumption that the investment climate over the last 3-5 years, during which many of these ETFs outperformed active managers, will be the same for the next 3-5 years. Certain passive ETF strategies are highly exposed to overvalued stocks and sectors that will not perform well as the macro environment changes.
In the last quarter of 2016, there was evidence of a shift occurring from the investment climate of the last two years. The prevailing macro environment of low to negative interest rates, low inflation, and weak global growth became challenged by new economic forces. Combine this with a new administration in Washington that is promoting pro-growth economic policies and we have a macro environment that is unlikely to follow past trends and be much more unpredictable going forward. This will have implications for asset class returns, and what worked well for passive investors in the past may not work that well in the future. An example of this shift from Q4'16 is shown in Figure 2. It compares the performance of the iShares Minimum Volatility Index ETF, a global smart beta ETF, versus the McLean & Partners Global Dividend Growth Pool, our global equity fund.
Source: CIBC Mellon, Bloomberg
In addition to changing macro conditions, we are also entering an era of low stock correlations. When the correlation across stocks is high, stocks and sectors tend to move together and the opportunity for active stock picking to add value becomes more challenged. This is one of the reasons why passive investment strategies have been mostly outperforming active managers over the last several years. Figure 3 shows sector correlations within the S&P 500 to be at 17 year lows and stocks have become far less correlated.
3-month average correlation of sector pairs (correlation of daily returns)
Source: Scotiabank GBM Portfolio Strategy, Bloomberg
Research conducted by BMO Capital Markets show that when stock correlations are low (as seen by the current levels), the opportunity for active stock pickers that follow a disciplined investment process to outperform the market is greatly enhanced.
As the macro investment environment continues to shift, stock correlations remain low, and the ETF universe continues to expand, we caution investors to be careful on what specific ETF strategies they employ and the risks they are inherently (and perhaps unknowingly) carrying in their portfolios. Strong historical performance does not automatically translate into realized returns in the future, and actual results will seldom match what the back tests indicate.
At McLean & Partners, we employ a disciplined stock selection process based on our philosophy of:
- Seeking the truth: Conducting fundamental bottom-up research analysis on the companies we own
- Being different: Being comfortable carrying different stock/sector weights relative to the index
- Being risk-minded: Allocating capital in a disciplined fashion towards the best risk/reward opportunities within our portfolio