Active versus passive investing in times of market dislocation
Stressed markets have gone through a period of extended market dislocation in recent weeks – when liquidity dries up and assets are no longer priced correctly on an absolute or relative basis. We look at the advantages and disadvantages of active and passive exposure under these conditions.
In a market freefall, you cannot escape gravity. In the absence of liquidity, all assets become subject to selling pressures, including those that are both passively and actively managed. However, by avoiding a blanket approach to exposure selection and applying an appropriate degree of due diligence, investors can be strategic in the use of both active and passive instruments in their portfolios.
Index investing, commonly through the use of exchange traded funds (ETFs), is one of the most broadly applied approaches in the passive investing space. Indeed, ETFs are excellent instruments that have a place within portfolios, particularly in the more-liquid asset classes such as core or large-cap equities; liquidity has not yet been an issue for these in the current bout of market stress.
However, ETFs in the less-liquid parts of the equities market, including small/midcaps and peripheral markets, have faced challenging liquidity constraints due to the nature of their underlying instruments. For example, a Philippines market tracking ETF was recently trading at as low as an 18% discount to its NAV (net asset value), meaning investors were willing to sell at prices worth one-fifth less than the underlying assets themselves.
“The key is to be well-acquainted with your managers’ style, consistency and investment processes through robust and long-term due diligence.”
Elsewhere, investing in fixed-income ETFs can be problematic. While in equities, there is a greater focus on distinguishing the winners from the losers, in fixed income, the objective is to avoid the losers – those issuers that will eventually default. Because default rates have been so low over the last decade of easy monetary policy, this rule of thumb can be more easily overlooked. High-yield debt has a default rate of 5-6%, on average. That means in an ETF basket exposed to this entire market segment, investors accept a 5% default rate in their investment. However, in fixed income, unlike in equities, gains are capped by the coupon (interest payment) and investments can go to zero in a default. So when default rates start rising, this can present real challenges and significant losses. It is especially critical to avoid those "torpedoes" (companies that will default) in the credit space – and to focus on distinguishing the winners from the losers in stock picking. This is where an active approach to selection is advantageous.
The other issue with fixed income-index replication is that it gives investors greater exposure to the most indebted issuers, which compose a bigger share of the index. Credit events like downgrades will hit the most indebted players hardest, so in times of market stress, it is all the more critical to avoid these issuers, which an active approach allows for.
The importance of due diligence
When correlations rise and fire sales are taking place across markets, whether your exposure is active or passive, your assets will fall with the rest on the way down. However, on the way up once markets start to recover, those investment instruments that are highest quality and most resilient, meaning with strong, well-disciplined balance sheets and low debt levels, will distinguish themselves from the rest. This is when active management can pay off. The key is to be well-acquainted with your managers’ style, consistency and investment processes through robust and long-term due diligence. This way when the recovery does arrive, you know exactly what your active manager is doing and can benefit from the selection process.
You cannot escape gravity – when everything is falling, there is no place to hide. The key rather is in doing your homework beforehand so that you know which investment instruments and active managers will be best positioned to benefit on the way up, having picked higher quality assets that will perform better in a recovery.
Alexandre Tavazzi, Global Strategist, Mussie Kidane, Head of Fund and Manager Selection & Jean-Marie Gaudichau, Advisory Funds
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