The Risk of Passive Equity Investing
The long bull market run following the 2008 global financial crisis has created considerable sector biases in all major equity indices across regions. In our view, the risk of concentrated positions in market capitalisation-weighted indices is now significant. Attempts to time the direction of the market or predict the bursting of a bubble are seldom successful. However, in light of the market turbulence earlier this year, we believe investors should be mindful of the increased risk of traditional passive investment strategies in the current market conditions.
Sector dynamics around market peaks
We conducted four case studies covering the US, Europe, Japan and Emerging Markets and focused on sector performance following the market peaks of 2000, 2007 and January 2018. The results were broadly consistent and showed that during most bear markets, the sectors that dominated the preceding bull run tended to underperform during the subsequent correction.
One clear example is the performance of the information technology sector at the start of the millennium. The internet boom drove strong increases in market capitalisation for Information Technology before the bubble ‘burst’ in 2000, leading the sector to underperform across all major markets over the subsequent three years. Telecommunication Services in Europe suffered a similar fate. Meanwhile, after enjoying strong market share gains prior to the 2007 market peak, Financials subsequently became the worst performers over the following three- and five-year periods in the US, Europe and Japan.
There are some exceptions, however, suggesting that the relationship between market weights and performance is not monotonic in all market corrections, especially over shorter periods. For example, during the correction in February 2018, the declines seen in the MSCI Europe index between 31 January and 9 February 2018 were similar across sectors. Nonetheless, we believe there is sufficient evidence of a trend to merit investors’ attention.
Alternative solutions at times of market stress
There are several active investment strategies that can help avoid this risk and potentially improve investment returns. A simple solution is a risk-managed equity strategy, which uses an optimisation approach to construct a portfolio that overweights stocks with low volatility as well as stocks with high diversification benefits. This type of strategy is likely to exhibit a more defensive profile during market excesses by underweighting momentum stocks. Factor investing is another approach that builds portfolios based on stock characteristics. Passive indices at market peaks often have a bias towards large-cap, growth and momentum stocks, which tend to perform poorly during market downturns. An actively managed factor-based strategy could avoid these biases and potentially deliver superior risk-adjusted returns.
Meanwhile, a carefully chosen combination of options, futures or swaps can add protection to an investment portfolio during times of market stress. As market turning points are difficult to forecast, unconditional hedging strategies with relatively low costs can be particularly beneficial. Finally, a dynamic risk allocation approach, which takes into account macro regimes in the asset allocation process, can be combined with any of the above strategies. This approach uses a combination of quantitative and fundamental analysis to predict when different assets enter higher volatility regimes and help time when to shift portfolio weightings accordingly.
In summary, in certain market conditions, such as market peaks, passive investing is encumbered with structural risks that active strategies can potentially avoid. While market turning points are notoriously difficult to predict, we believe investors should factor this risk into their wider investment strategy and asset allocation decisions.
This document is based on our opinion and has been prepared for information purposes only. It constitutes neither investment advice nor recommendations. It does not represents an offer, solicitation or suggestion of suitability to subscribe in the investment vehicles it refers to. The investment strategies described or alluded to herein may be construed as high risk and not readily realisable investments, which may experience substantial and sudden losses including total loss of investment. These are not suitable for all types of investors. Some of the information contained in this document may have been derived from third party sources. Unigestion takes reasonable steps to verify, but does not guarantee, the accuracy and completeness of such information. As a result, no representation or warranty, expressed or implied, is or will be made by Unigestion in this respect and no responsibility or liability is or will be accepted. All information provided here is subject to change without notice. It should only be considered current as of the date of publication without regard to the date on which you may access the information. Please contact your professional adviser or consultant before making an investment decision.