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Square Mile: Time to pass on passives?

They are simple and cheap, but might not necessarily equate to better performance

Passive investment strategies continue to gobble up market share. Why shouldn’t they? Active funds generally had a miserable 2018 and the majority of funds in the Investment Association UK All Companies sector lagged behind the FTSE All-Share index.

For advisers, passives are relatively simple to monitor and at a time when the regulator is focused on value for money, the cheap option appears the easy way to discharge regulatory responsibilities. How many compliance officers will berate advisers for using a passive strategy?

But does cheap necessarily equal better? I oversee Square Mile’s managed portfolio service. At the beginning of 2018, we switched the majority of our UK equity exposure to passive funds. This may surprise many readers, although we expect to reverse this move during 2019.

Logical choice?
Few professional investors and financial planners will be unaware of the compelling logic favouring passive investment strategies. After all, equity market indices represent nothing more than the performance of the average share. If someone is doing better than average, logic dictates someone else must be doing worse than average. Active management involves greater costs than simple replication strategies.

Lower-cost passive funds are therefore almost bound to outperform the average active manager – in theory.

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In practice, I think this broadly holds. With a little work, however, we believe it is possible to identify funds that will outperform in a predictable manner.

But some markets are more efficient than others. The US equity market is notoriously efficient. The UK market is probably not so efficient and there does appear to be greater evidence that the average professional active manager can add value, at least before the costs of their fees are taken into account.

In the portfolios that Square Mile runs, we tend to favour passive management in North American equities and typically lean towards active management in UK equities. But 2018 was an exception.

Experience has taught me that as bull markets mature, momentum trends become increasingly entrenched. Investors get greedier as returns from stockmarkets become “easy” and the pain experienced in the last bear market becomes more distant. New investors are attracted by the rising market and often focus on the stocks with rapidly appreciating prices.

This additional demand bids up prices and something of a virtuous circle develops, escalating the speculative fever. In early 2018, the huge gains in e-commerce firms were beginning to get attention as the prices of “Faang” stocks (Facebook, Apple, Amazon, Netflix and Google) soared.

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Active managers tend to avoid expensive stocks and follow discerning valuation disciplines. However, history has taught us that speculatively fuelled momentum trends can push prices of expensive stocks far higher and for far longer than a rational person might expect.

We suspected 2018 would prove to be a difficult year for active managers while this continued.

That, coupled with a desire to lift energy exposure in our portfolios, led us to reorient them towards passive FTSE All-Share index funds at the beginning of 2018.

Cheap and well-run FTSE All-Share index funds such as those provided by BlackRock iShares, Legal & General Asset Management and Fidelity outperformed 70 per cent active funds. FTSE 100 trackers were even more successful, like the HSBC FTSE 100 Index fund.

Reopening the door
We believe the unusual conditions which pushed tracker funds to elevated peer group positions are no longer in place. The steep correction experienced by financial markets over the fourth quarter has blown away much speculative froth. The momentum trend should begin to break down, opening the door for active managers to add value.

So which active funds will outperform in this environment? That’s a tough question. In previous Money Marketing articles, I have highlighted the steps you need to take to identify funds that will offer long-term outperformance. Future articles will provide further clues as to what to look for.

Jason Broomer is head of investment at Square Mile Investment Consulting & Research

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