The financial industry has long pondered the question of whether active or passive investing is better for a portfolio. It is hotly disputed which strategy is superior. Which is why the focus of the debate should be on the question of how an investor best combines the two philosophies across an investment cycle.
Active managers spend a lot of time identifying investment opportunities in their market segment. They are looking for incorrectly valued assets whose fundamental value has yet to be fully realized. In contrast, passive investing is based on the idea that the indices themselves offer the most efficient access to a broad market. The two approaches seem so contradictory that they are often played off against each other in an active versus passive tug of war. In reality, however, they complement each other.
In the real world, the financial markets reflect their broad-based economic, political, and regulatory environments. Market drivers evolve over the course of a business cycle in the same way that conditions do. Consequently, the question arises when and how to adjust the combination of active and passive investments as external conditions change. Sometimes a pure market exposure – known as beta exposure – provides an adequate return, and there is little scope to generate excess returns – alpha. In another phase, inefficiencies provide the opportunity for active managers to achieve an above-average performance. The optimal strategy, however, often contains different gradations of both approaches.
What exactly does this mean over the course of a typical cycle? In the recovery phase at the beginning of a new upturn, growth is picking up and central banks loosen their monetary reins. This provides the recovery with additional momentum. At this point, a passive focus on an index can generate considerable returns as positive investor sentiment drives all stocks higher. However, the early recovery phase can also be profitable terrain for active managers. In particular, value investors who bought beaten-up stocks in a bear market that is drawing to a close are able to benefit strongly.
In the middle of a cycle, the different asset classes usually begin to correlate strongly and show low volatility and narrow dispersion. Under such conditions, passive strategies in the past have proven to be good alternatives for gaining cost effective market exposure, or in other words, beta exposure. In this phase, active managers can generate only modest added value – if at all. A prime example of this is the most recent, long-lasting mid-cycle stage through 2017, which was fueled in part by the quantitative easing programs of the major central banks. In an environment of extremely low volatility, opportunities for active managers to generate added value were relatively rare in many markets.
In the late cycle – which often features rate hikes by central banks to keep inflation from heating up – the probability of a turning point increases and the market environment becomes more challenging. Volatility rises, dispersion increases and the correlations of assets change. Risk aversion increases, so that equities with a lower beta and defensive character have an attractive risk-return profile.
While passive index strategies participate fully in rising markets, they also face the full drawdown when markets reverse direction. In such an environment, where a pure market orientation – beta – is questionable and investors shift their focus to capital preservation, active managers prove their worth. An active manager can make a big difference during a downturn. Arbitrary, herd-like selling on the markets is by its very nature inefficient, creating the basis for active investors to exploit these information advantages and to generate added value versus the broad market. Quality-oriented strategies can be particularly advantageous, as companies with solid fundamentals in the form of consistent and predictable profits as well as good governance and healthy balance sheets become increasingly attractive.
With regard to the current cycle, conditions have changed considerably since the good days that lasted from 2017 until the end of summer 2018. The developed markets are giving off some late-cycle signals as growth momentum is slowing, central banks are tightening their monetary policies, and rising oil prices are putting additional pressure on inflation. Meanwhile, market volatility has risen from its record lows, and correlations between individual assets have declined.
A recession looks unlikely in the short run. But when it comes to portfolio construction, somewhat more caution is advised in order to stabilize returns and to protect capital against a potentially more turbulent scenario. It is probably a good time to reduce the beta exposure overall, as the markets adjust to a less upbeat economic outlook. Passive strategies, taken alone, are not particularly helpful in reducing risks. After all, they essentially represent a broader index. If the external conditions become more uncertain, the markets will often react accordingly. As always, the key for building a robust portfolio is diversification. It currently looks like a good time to adopt an active approach to asset allocation, an approach that is followed by experienced, active managers. The time for adding passive instruments to a portfolio to benefit from market trends on a more cost-efficient basis will certainly come again.
Head Multi Asset Asia
The LGT Investorama we can only show you depending on your country of domicile. To download this document onfrom our webpage "Market information" please go to “Domicile selection” first.