So, if too many investors are pouring into passive strategies, assets might end up being misvalued, in terms of their underlying risk or profit profiles. Is that what we’ re seeing now? Large cap stocks are now more highly valued than small caps, but historically the opposite was true, as investors considered small companies to have greater room for long-term growth.
Both strategies have their place.
You could argue that the valuation increase for large cap stocks isn’ t a mistake, but is justified by their long-term profit outlooks. Who’ s to say that the previous assumption – that smaller companies will do better of the long-term – is any better than the current profit assumptions. Certainly, the biggest US tech stocks look best equipped to exploit future growth opportunities like AI, despite new market entrants, either through their own development or by buying up smaller competitors. Passive investing seems to fit this environment.
Based on history, however, you would think that at some point investors’ relative valuations will shift, and at that point, active stock pickers could stand to gain. They do best when there is a lot of divergence in outcomes – and most expect this divergence to come now. In simple terms President Trump, for example, is considered good for US domestic growth and bad for everywhere else. That means uneven opportunities and risks, precisely the environment that favours a discerning investor.
Markets need some active investors.
Arguably, the structural flow of investment towards passive strategies is bad for the functioning of markets as a whole. Diversification – spreading your risks and rewards across many assets – is a key principle of investing, but the more markets are concentrated on a handful of established names, the narrower the breadth. This means less diversification in index-tracking funds, because the index has such a big weight to a small number of stocks. We certainly see this narrowing of market breadth now.
Passive investors essentially rely on the market to decide asset valuations – but the market is just made up of investors buying and selling, usually based on their own valuations of assets. Imagine you want to work out how much an asset should be worth, but instead of evaluating the asset itself you just estimate based on what everyone else thinks it is worth. You essentially herd towards the average valuation – which can make your individual valuation of the asset more accurate. But if everyone is herding towards the average, then the average itself becomes less accurate.
Ultimately, both active and passive strategies can be good ways to invest, and the decision should be about much more than just cyclical under or overperformance. Many investors prefer a blend of the styles, to get the right mix of investments in their portfolios. This blended strategy is very popular among our own clients, as it gives investors exposure to the potential outperformance than can come from active management, while also being exposed to the broad market trends. Investors should consider their own priorities and how those might be impacted by the activepassive cycle.
PLEASE NOTE
Any reader should not use this article as a guide or form the basis of a decision relating to the specific investment objectives, financial circumstances or particular needs of any recipient and it should not be regarded as a substitute for the exercise of a professional advisers’ own judgement or the recommendations they may make.
48 | The Adviser