The active versus passive debate is clearly one of the most polarising arguments in the investment industry today. But at Ashburton Investments, we do not believe it should be an argument at all. To us, passive investing has been a positive development for the industry.
There are thousands of easily-replicated indices and benchmarks in existence today, across many asset classes, and it is only right for investors to have an option to track these markets at a low-cost.
Passive does have a role in investment markets, but what explains its stratospheric expansion in popularity over the past decade? To us, the answer lies in the economic environment we have witnessed over this period.
In the wake of the Global Financial Crisis, many major economies undertook largely coordinated efforts to expand balance sheets and provide almost infinite liquidity to the system. The by-product of quantitative easing, combined with ultra-low interest rate policies, has been the dampening down of volatility.
In this environment of low volatility, risk management mechanisms like stop-losses and margin-calls have not been triggered as they would under normal conditions. Hence there has been limited downside to applying simplistic filters to capture the beta of various style factors – such as quality or momentum. With no sustained periods of volatility, the human element of managing risk and liquidity has largely not been required. There have been few negatives to utilising passive investments.
However, with volatility at the lowest levels in modern history, the frequency and amplitude of volatility spikes is likely to increase moving forward. We are now in an environment of interest rate hikes, for the first time since the end of the Global Financial Crisis, while the other monetary policy efforts are set to begin unwinding. We would argue it has been the abundance of liquidity, rather than any economic expansion, that has played the major part in the sharp rise for asset prices over the past decade.
The current combination of high leverage ratios and low volatility is a dangerous cocktail for investors against a backdrop of rising interest rates, particularly with volatility set to return. Leverage is a friend for investors as long as volatility stays low, but is dangerous if it reverses. Severe volatility on leveraged portfolios has often led into the territory of stop losses and fire sales to meet margin calls. This is what occurred in 2008 and other significant breaks in the market.
The likely return of volatility is precisely why we believe the pendulum will swing back towards active management. While we are not calling an end to the bull market, we believe we are entering a period where the risk factors and portfolio allocations require a greater degree of active management to diversify risk from predominantly passive exposure.
This environment should highlight the strengths of a firm such as Ashburton Investments. We believe our future is firmly fixed in active management – across our multi asset capabilities, specialist equity solutions and bespoke portfolios.
Investors should not underestimate what impact a ‘new normal’ of heightened volatility may have on investment markets. Once markets are freed from the underwriting efforts of global central banks, volatility will rise and the massive tailwind seen for passive investment over recent years will peter out. True active management and the ability to adapt will be vital as this pendulum swings Portfolios should be constructed to include the benefits of both passive indexation and increasingly active risk management.
Steve Kelso is chief executive of Ashburton Investments (International)