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Capital market risks loom if passives dominate

Stocks

The rise in passive investing puts the whole essence of capital markets at risk as there is no discrimination between good and bad stocks, according to Syz Group.

The Geneva-based banking group’s chief executive, Eric Syz said if index funds eventually dominated the fund world then everyone would have an equal share of the index and there would be no selection to reward well run companies or to sanction bad companies.

Tipping point 

However, Syz told Expert Investor that the likelihood of this happening some way off away but markets were heading in the direction for passives to dominate.

“It’s probably going to take a long time but there will be a tipping point where active managers, because there will be fewer and fewer of them, will potentially have a big enough influence to move stocks,” he said.

“This is because it will take very little capital to buy or sell a stock because nobody is on the other side to absorb it when everyone else is an indexer.”

Syz said indexers would either have to invest something new or become active managers themselves as there would no longer be added value for them.

“I’m very convinced that in the next 20 to 30 years active managers will have the upper hand,” he said.

“I think a good combination is that there should be enough managers who are not an index part, who are alpha generators to have a healthy counter balance.”

Volatility risk

Syz noted that there was a clear herd mentality going on with passives in the market and that good economic theory needed a good countermovement – active management.

“I think the question is how long will the low volatility prevail? Is it the new reality? And I would say ‘no’. On the other hand, with less and less liquidity, an accident is bound to happen and we saw it happen with volatility spiking,” he said.

“Because volatility is close to zero there is no market intervention, no opinion in the market, everybody does the same thing at the same time all the time and we all know that’s not going to happen. I think it’s an illusion for people to think that volatility will stay low.”

Syz said he would never buy a passive fund and nor would his firm’s wealth management business.

Fees

He said fund selectors needed to pick managers that had a repeatable and consistent process, and that fees were not an issue if a fund performed well.

“People always haggle on fees, but fees are only a problem when the product is bad. When the product is good, fees are never a problem. And that is in any industry,” Syz said.

“Let’s take hedge funds for example who in the good days for 10 years in a row were cranking out 20%+ every year net to the customer but they had very high fees. Some people said ‘I’m not going to pay the high fee and I prefer to have much lower fees but only make 5% a year’.

“It’s a choice, I’m not saying it’s good or bad. You have a choice to pay 20% fees and get 30% in your pocket or pay 1% fee and make 5%.”

Passive crowding

Agreeing, JO Hambro Capital Management fund manager, Mark Costar said the rise in passives had a huge and profound impact on price formation in markets as a lot of people bought and sold the same stocks for the same reasons at the same time.

“This crowding results in equities becoming reactionary rather than anticipatory mechanisms. They’re not predicting or anticipating like before,” he said.

“The more data or more data scientists does not mean better results. It doesn’t fundamentally yield better outcomes. Investment performance and underperformance will come in more powerful concentrated bursts. And the question is: are asset managers aware of this?”

Costar said the change in price formation was likely to be the new normal and that the decline in long term equity ownership would continue.

“We will never out react machines – we need to do something different from them. We need to be exposed to different and unique information sources, have different fundamental long term approaches and look very long term – this is something machines aren’t good at,” he said.

“Crowding risk needs to be monitored carefully and the best way is to own assets that others do not own or own the same assets for different reasons and you’ll be less likely to get caught up in bad results.”

A combination

Legal and General Investment Management chief executive, Mark Zinkula said he believed in using both actives and passives at the same time.

Responding to data showing that index funds had risen from 20% in 2008 to 37% in 2018 in the US, and 10% in 2008 to 16% in 2018 in Europe, Zinkula said he expected passive funds to increase in popularity a decade ago but did not expect the magnitude in which it had increased.

“The focus on fees has been more pronounced in this low interest rate environment and this has cause more passive growth,” Zinkula said.

He said in the US the main driver for passive funds was the focus on eliminating commissions and fees.

“We manage around 20% in traditional active funds, 50% outcome orientated funds, 20% in passive funds. We believe in both,” he said.

“We never debate which is better or worse as it depends on client objectives and we develop products that are suitable to meet those objectives and fees that are fair and transparent. For a lot of clients it’s a combination of both active and passive.”

Zinkula noted that while self-indexing was becoming a trend, the extent to which would depend on how willing asset managers were to incur costs and risks in calculating indices.

Jassmyn Goh

Jassmyn reported from Sydney to New York to Jakarta before joining Expert Investor. She was most recently Features Editor at Money Management and Super Review in Sydney.

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