Why passive investing now won’t deliver all your goals

Passive investment funds used to be a relatively obscure part of the market. But with their popularity soaring in recent years, many investors might now be sceptical about paying for active investment.

Market performance over recent years would reinforce that scepticism. Holding a passive mix of mainstream assets has performed very well over the last 5 years.

For example, an investor who suffers a permanent 25% loss of capital at age 30 is expected to have a 0.8% reduction in their retirement balance at age 67 as a result. Even at age 50, a 25% drawdown is only expected to reduce the saver’s balance at retirement by 7%. However, at age 60, the loss more than doubles, shrinking the balance at retirement by 17%. At the point of retirement, age 67, a person’s retirement balance reduces by 25%.

Advisers should now be questioning the ability of passive investing to deliver each client’s goals, and carefully analysing whether active management is more suited to a client’s life stage and goals.

Riding the tailwinds

Adherents of passive investing have had a strong story to tell in recent years. They’ve popularised research that shows passive investing has outperformed active investment over certain periods. And there has been a growing emphasis on the impact of management fees on long-term investment performance.

But the investment environment has also been favourable to passive investment in recent times. Passive investors have had to merely sit back and ride the strong, clear trends.

From 2012 to now, a post-GFC cyclical rally saw the major asset classes deliver strong returns as economic growth and US earnings strengthened. US shares, which make up around half the MSCI world index, particularly outperformed, driven by a low US dollar and a surge in earnings.

Bonds delivered one of the largest rallies in history as Central Banks pushed interest rates close to zero, and in some cases below.

That strong period for bonds also gave investors an incentive to seek higher returns in shares and, more broadly, risk assets. Shares and bonds, which normally zigged when the other zagged, were highly correlated this time and both provided strong returns for investors at the same time.

What’s more, the falling Australian dollar from pre-GFC highs boosted the returns of unhedged index funds.

From tailwinds to headwinds

But we believe those very tailwinds that drove outperformance in recent years could likely become headwinds.

We are particularly concerned about US equity markets. We think the region could significantly underperform as monetary policy tightens and the rising US dollar restricts growth. US Equity markets are at very high levels on many measures, despite the pullback and subsequent bounce in early February. With US inflation and Fed expectations still moving higher and Trump adding to the inflationary pressure in the US with tariff hikes, share markets are likely to remain volatile in the short-term with a high risk of seeing a re-test of February share market lows.

We are also concerned about ‘duration risk’ and the impact of rising interest rates on bonds. The longer the duration, the bigger the falls when interest rates rise. Unfortunately, the duration of fixed-income indices has lengthened at potentially the worst point in the cycle. (The duration of the Australian fixed-income index (Bloomberg AusBond Composite) is now 5.24 years, up from 3.5 years before the GFC.)

Investors passively invested in global bonds could be exposed to capital losses if yields rise from their record low levels. Those risks, relative to expected returns, are at all-time highs.

Big losses from passive investments

Many investors are focused on the low cost of passive investing, which over time can make a significant difference to returns.

Advisers need to remind clients that active management, particularly at the asset allocation level but also at more granular levels, is most effective in periods of greatest turmoil.

Controlling losses is important. A portfolio that has shed one-third of its value requires a significantly larger gain – 49 per cent – just to recover prior losses. If those large losses can be avoided or reduced, then an investor’s wealth accumulation will be significantly enhanced.

A closer match with investors’ life-stage and goals

Investors with longer-term horizons, such as younger people in their early accumulation phase, are better able to weather large losses. Markets do recover and they can simply choose to ignore the market fluctuations and ride out the market cycle.

But those losses can have a significant impact on investors with a shorter-term horizon, and particularly those close to, or at, retirement. Passive investing, particularly, removes the potential for those losses to be managed and increases an investor’s exposure to sequencing risk – the risk of a large loss just before or after someone retires, which can lead to a significant cut in standard of living.

In this environment we believe advisers need to more closely match an investor’s life-stage and goals. Younger investors often have less requirement for active management of portfolio risks and can have a greater allocation to passive investing; but investors close to, or in, retirement, advisers need to consider more actively managed solutions that have are designed to effectively manage risk and in particular are focused on managing the impact of large losses.

An active reconsideration

We believe reconsideration of active investment to navigate market risks and to protect capital.

The new environment will be characterised not just by low returns, but by greater volatility. Investment cycles are shorter and sharper, and risk flares look to be a more regular occurrence.

Active management allows investors to negotiate the ups and downs of the market cycle. Assets that aren’t expected to provide reasonable total returns, or that have excessive downside risks can be reduced or avoided. It also allows investors to exploit opportunities that volatility throws up with fewer restraints than passive investing.

Passive investing, for the time being, is restricted to traditional asset classes like shares and bonds. We think that in the current environment portfolios also require more alternative sources of risk to help compensate for the low returns on offer from bonds. Strategies that focus on generating returns regardless of market direction or come from the ownership and management of specific assets such as Infrastructure are essential components of portfolios expected to navigate what’s ahead of us, and these strategies are only available within actively managed funds.