The page you were trying to view is not available for your role.
Show me the money
It’s the same old story: active managers can’t reliably beat their cheaper passive counterparts. For years, there has been a steady flow of investors going passive and switching out of active funds into index trackers. These days, many wonder why anyone would still bother with the higher cost and additional risk involved with active investing as they watch the Nasdaq 100 climb ever higher.
While no one can dispute that passive funds are generally cheaper, it takes quite a lot of mental gymnastics to claim that passive investing is lower risk, given what many of these apparently diversified indices now look like.
We all know how top-heavy the US equity market has become. The 10 biggest stocks now make up nearly 40% of the index, and 9 of those 10 stocks are in the tech or tech-adjacent sectors. Rather than making a broad bet on the growing profits of US companies, passive exposure to the US large-cap index is becoming an increasingly concentrated bet on AI.
I feel the need, the need for speed
A similar thing is happening in the Asia Pacific ex-Japan region too. Taiwan Semiconductor Manufacturing, or TSMC to its friends, was a 9% weight in the benchmark around a year ago, but now it has risen to 14%. This means managers of UCITS funds are forced to be underweight whether they like it or not, as they are capped at 10%. Korean memory stocks are on the rise too: Samsung has gone from a 2% weight to 7%, and SK Hynix has gone from relative obscurity, at under 1%, to more than 5% today.
Of course, the reason for these stocks’ growing weightings is their pretty racy performance. TSMC, the laggard, has more than doubled over the past year; Samsung has returned more than 360%, and SK Hynix is up more than 700%. Meanwhile, the entire index has managed only 40%, and these three stocks alone accounted for about two-thirds of that.
In a game where even the very best barely get more than half of their calls right, this is a horrible market environment for an active manager trying to outperform the benchmark. They live or die by their calls on just a few stocks, so why would we want to take on the risk of underperformance?
You complete me
In fact, most active managers in the region are almost certainly far less ‘risky’ than the benchmark, if you think of risk in an absolute sense rather than using the benchmark as your starting point. Their portfolios will be less concentrated and set up to perform well in many more market environments than the top-heavy, tech-dominated index. Of course, the environment we are living through now is the one best suited to passive trackers, but if the tide turns on those three stocks, it would be very painful.
All this is to say that whether you are buying an active or a passive fund, you need to understand exactly what you are buying and where the risks lie. Switching to passive options because they have done better may paradoxically worsen portfolio diversification and expose investors to a greater risk of capital losses.
In our team, we often say that we aim to construct portfolios that give us as many ways to win as possible. We want to have exposure to several market outcomes rather than anchor ourselves to a single most likely scenario, because no one really knows what the future holds. While these concentrated tracker funds may keep on going, there aren’t that many ways for them to win, so passive investing is increasingly becoming risky business.
Key takeaways
- Passive does not mean lower risk, especially when an index is less diversified than it used to be.
- A concentrated portfolio works brilliantly on the way up, but it can leave passive investors painfully exposed if the market turns.
- Active managers may not win the performance race in narrowly led markets, but many are running more balanced all-weather portfolios than the benchmark.
CJ Cowan
Portfolio ManagerCJ is a portfolio manager of the Quilter Investors Cirilium and Monthly Income Portfolios. CJ joined Quilter Investors in August 2018 from Aberdeen Standard Investments where he worked in the global macro team, managing global government bond and global aggregate portfolios.
CJ is a CFA charterholder and has also completed the Chartered Alternative Investment Analyst qualification. CJ has a degree in economics from the University of Bristol and an MPhil in Economic and Social History from Brasenose College, University of Oxford.
