Practice Management

An active response to problems with the passive case

When the US accounts for two-thirds of global equity indices then there is a problem being entirely passive. Active investment management can side-step lop-sided indices.
December 2020

Mark Parry

Director,
Head of Strategic & Technical Sales

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Risk Disclaimer 

Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management.

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

When the US accounts for two-thirds of global equity indices then there is a problem being entirely passive. Active investment management can side-step lop-sided indices.

The outperformance of a narrow section of the global equity market has created an issue of concentration in global equity indices. We believe that this should prompt a review of investment propositions that are reliant on passive investments. This problem is one of success, as it has driven the strong performance of many passive multi asset investment solutions, however, in the investment industry, we can never rest on our laurels, we constantly have to review our propositions, our products, our risks.

Cost, performance and diversification – what every proposition needs

The passive case for investments in the past has rested on three pillars, cost, performance and diversification. Passive investment propositions were significantly cheaper, and this lower cost was a useful source of performance. The key performance driver was maintaining full index weightings in the US technology based megacaps that have led stock markets for most of the past decade. Straightforward asset allocation models have delivered on diversification and on risk targets.

Facts & stats

MSCI World Index - As a percentage of the index

Top five companies

14.2%

IT and Communication Services sector

 

30.8%

US

66.8%

Price Earnings Ratio

24.5

Annualised standard deviation

17.1% over 3 years

* figures MSCI 30 October 2020

Crash revealed risk nearly as high as emerging markets

The concentration risks of the MSCI World Index are not just theoretical, the annualised standard deviation of the index has risen to average 17.1% over the past three years. This index saw its largest fall this year, outstripping losses during the global financial crisis. Interestingly that was not the case for emerging markets, which fell barely more than MSCI World Index during this crash

Purely passive propositions lack levers to pull

This sort of risk is not easily addressable within an all-passive proposition. Standard asset allocation processes may not respond in a timely fashion to the recent rise in index volatility and will certainly not take account of valuation issues or potential shifts in style from growth to value. Yet we will still have to justify to clients the decision to invest 14% of the global equity allocation in five US stocks.

Active management is now cheaper than you think

So, time to take another look at active management as a component that could help to balance these risks? But what about costs? Here the market has also moved on and passive multi asset investment solutions are no longer automatically cheaper than actively managed solutions. Even where passive is still cheaper, the cost differential, like-for-like, is a fraction of what it was.

An active response to problems with the passive case

Active management can side-step lop-sided benchmarks. Active management means that the issues of market distortions and mispricing can be addressed at the appropriate level, through active management of asset allocation, sector or stock selection. Risk management can encompass value versus growth styles and can look for macroeconomic correlations to ensure that the risks taken are as a result of active decisions.

Risk Disclaimer

Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management.

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

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