{"id":1220,"date":"2022-09-30T04:58:00","date_gmt":"2022-09-30T04:58:00","guid":{"rendered":"https:\/\/halcyonpw.com.au\/?p=1220"},"modified":"2022-10-11T05:09:18","modified_gmt":"2022-10-11T05:09:18","slug":"market-update-the-decision-to-be-passive","status":"publish","type":"post","link":"https:\/\/halcyonpw.com.au\/market-update-the-decision-to-be-passive\/","title":{"rendered":"Market Update | The Decision to be Passive"},"content":{"rendered":"\n
Key Points:<\/em><\/p>\n\n\n\n What does it mean to be passive when investing? In this month\u2019s Insight <\/em>we outline our thoughts on the concept and some of the confusion and misconceptions stemming from it. We don\u2019t think any investor can be truly \u201cpassive\u201d. Because passive investment has become so popular and widespread, it has for many taken the mantle of a risk-free decision. We strongly disagree with this, there is no risk-free position in investment management and every decision (even the decision to not make a decision) has consequences.<\/p>\n\n\n\n Market Cap, Quantitative, Fundamental or a Dartboard?<\/em><\/strong><\/p>\n\n\n\n Most commonly, a passive investment strategy refers to an investment product which replicates the performance of a market capitalisation weighted (cap weighted) equity market index. A cap weighted strategy weights the securities in the portfolio by market capitalisation (the total value of a company\u2019s shares). The largest companies get the biggest weight. Quite simply, you are buying a slice of the overall market. A benefit of this approach is the very limited need to rebalance. The weight of individual names in the portfolio will grow and shrink with their respective market moves. The huge amount of money invested in market cap strategies and their simple implementation makes their fees lower than more complicated investment strategies.<\/p>\n\n\n\n Low fees and strong performance versus alternatives since the Financial Crisis have made market cap allocations an attractive option for many investors. Despite this, the academic and empirical support for passive is relatively mixed. S&P data (SPIVA Scorecard) shows that most active managers have underperformed their respective benchmarks after fees over the past decade. However, academic research has also shown that even most random portfolios will outperform market cap in a back test. How is this inconsistency possible? Well, it turns out that the small cap and value styles of equity investing (effectively the antithesis of market cap, which holds big, expensive companies) have such strong performance effects over time periods greater than the past decade that simply by having some exposure to these factors a random portfolio should outperform the market cap benchmark[1]<\/a>.<\/p>\n\n\n\n We think in practice, most of the swings and roundabouts between the relative performance of active and passive styles has more to do with the overarching investment environment than anything else. Market cap indexes have the biggest weight in the biggest companies. That means when the largest companies are doing well, market cap indexes will do well. The period following the Financial Crisis, which involved a substantial concentration of market power in the largest US technology companies, has been a phenomenal return period for the largest companies and therefore market cap weighted portfolios relative to their alternatives. Since 2021, we have seen a partial reversal of that trend, with value managers in particular doing well as real interest rates have risen.<\/p>\n\n\n\n As active asset allocators, our role is to determine which style should perform best given our view of the investment environment and to select which strategies align with that view. If that view suggests an active style, we will try and find one of the few that consistently outperform market cap. Like picking stocks, picking between active managers or market cap strategies is a difficult exercise which takes considerable skill.<\/p>\n\n\n\n The Elephant in the Room<\/strong><\/em><\/p>\n\n\n\n Most will be aware that there has been lots of focus and conversation on passive versus active management and the various performance of different equity styles through time and fee savings et cetera. Having been happy to participate in that debate and share our view above, we now need to turn to the aspect of investment decision making which actually drives the vast majority of outcomes \u2013 asset allocation. Often, investors will prosecute a debate about picking active equity managers versus passive index trackers seemingly endlessly and give very little airtime to how much equity exposure they actually need in their portfolio versus other asset classes. What should their regional exposure be? Should they employ a tactical asset allocation process? Focusing entirely on building the equity allocation in a portfolio, risks fiddling while Rome burns.<\/p>\n\n\n\n Unfortunately for investors hoping to employ a passive investment decision making process, there is no option to passively determine an asset allocation. With multiple asset classes and multiple decisions within each asset class required, someone needs to make a call on the appropriate portfolio. From an Australian investor\u2019s perspective, even constructing the notionally simplest portfolio possible \u2013 a 70\/30 equities\/bonds portfolio split between Australia and the rest of the world comes with important decisions. Below, we show the results of our capital market simulation model on two versions of the above portfolio \u2013 one with a small home bias (~1\/3rd<\/sup> Australia) and one with a large home bias (~2\/3rds Australia). Between the two portfolios there is a 30-basis point difference in expected returns at the 50th<\/sup> percentile. The small home bias portfolio also has a fatter right-hand tail in its distribution (more potential upside).<\/p>\n\n\n