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CIO reveals how to navigate risk with passives

CIO reveals how to navigate risk with passives

This article was written by Cássio Valdujo, chief investment officer at V3 Capital Partners and was published in the September issue of the Citywire Switzerland magazine.

Passive investing has become more of a hot topic than ever before in recent years. We have seen passive strategies become the go-to investment choice, with investors piling into funds and ETFs regardless of their level of sophistication or investment experience. Such a surge in popularity can be attributed to any number of reasons, ranging from the democratisation of ETFs via low fees to the virtually unlimited supply of new products.

Conditions have also been conducive to this trend, as the combination of many years of cheap money, strong global economic growth and a low inflationary environment has generated one of the longest bull markets since the stock market crash of 1929.

A turn for the worse

While passive investing has enjoyed continuous success over the past nine years, active managers have paid the price. They have struggled to generate enough alpha to perform better than the market, when taking into consideration their more substantial fees. The reason behind this is not that managers forgot how to turn a profit, but rather that passive investing has changed the way the markets behave by becoming something of a self-fulfilling prophecy.

The more investors bought broad index ETFs, the less active managers were able to profit from purchasing cheap stocks and selling expensive ones. The cheap ones remained cheap, and whatever was expensive became even more so as latecomers continued to jump in, not wanting to miss the party. On top of that, investors fed up with high fees from active investment managers have jumped ship and poured even more money into passive strategies, exacerbating market distortions and pushing valuations even higher.

Passive investing may have legs under the current conditions but as soon as markets begin to falter it is likely to be a very different story. Due to the nature of ETFs, when investors try to get out en masse, they will all be selling the same holdings at the same time, with no buyer of last resort at the other end.

The exceptional bull market and a previously unseen volume of passive investments make it very difficult to predict the impact that a sell-off will have on the markets. However, the mini-crash earlier this year could easily end up looking like a blip in comparison.

A new dawn

Not everything is bleak in the passive investing world though – quite the contrary! With the range of new products available to investors constantly growing, it is much easier to find passive ways of gaining exposure to specific sectors or themes.

One way this can be done (apart from a simple sector-specific ETF), is by employing a smart beta strategy, using factors such as momentum, high dividend yield, low volatility and value.

This strategy generates greater returns than a market capbased index, where the companies with the biggest market caps have the biggest weightings.

The irony is that by managing a portfolio to avoid certain exposures or risks by focusing on specific portions of the market, passive investors are, in a way, managing their investments similarly to active managers. It is the natural evolution of investing, and at V3 we believe it is a welcome development. It is passive investing 2.0: transparent, cost-effective and – why not? –‘actively’ managed.

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