Will Covid-19 expand passive investing’s appeal?

This article was adapted from a feature story that originally appeared in AsianInvestor's Spring 2020 edition, which was published just as the coronavirus was spreading in early March. 

 

The past few months have caused a litany of bad news for CIOs across the world. From the US Federal Reserve’s emergency rate cut on March 3 to a succession of further cuts in the US and across the world, interest rates have been cut to bare bones levels even as stock markets have plummeted. 

 

The reductions have been part of a broader based monetary and fiscal reaction to the torrid economic impact of the spread of Covid-19. However, the drops in interest rates in particular underline just how difficult asset owners are finding it to secure predictable, decent returns.

 

Current conditions could make it easier for some astute active fund managers to beat the market. But the volatility across entire asset classes makes the hunt for alpha very challenging, and the losses accured across the first quarter is only making it more important for asset owners to try and cut costs to the bone in the mainstream parts of their portfolios. 

 

It's a little early to conclude that active managers won't outperform their passive rivals. Famed investor Warren Buffet noted that investors should bet on America, but be very careful on how they did so during the coronavirus, just after revealing he had dumped all of Berkshire Hathaway's airline stocks. 

 

However, there are signs that many active managers have struggled to fall slower than dropping markets. A report by SCM Direct in early April, for example, indicated that the average UK active manager underperformed their benchmarks by 2.1% between January and the end of March. And Buffet himself said he would "disagree violently" with the idea that passive investing is dead. 

 

Existing players certainly appear concerned that passive investing will continue to rise. Witness UK wealth manager St James's Place, which just announced plans to launch passive funds for the clients that have given it £100 billion ($121.36 billion) in assets. 

 

TAKING STOCK

 

Equities is proving to be particularly vulnerable to further potential shifts to passive investing.

 

Market performance statistics don’t lie; at this point it’s evident that over the decade until late 2019 very few actively managed equity funds managed to beat their index benchmarks. 

 

In September 2019, fund research provider Morningstar released 10-year performance statistics. It revealed that just 23% of active funds beat passive rivals over the previous 10 years, and that the cheapest passive funds outperformed their priciest rivals more than twice as often. 

 

That has led more asset owners to ramp up their passive investments. 

 

“At this point about 75% of our total exposure in public equities is invested through external asset managers via index funds or ETFs,” said Jang Dong-hun, chief investment officer of the W13.9 trillion ($11.7 billion) Public Officials Benefit Association (Poba). 

 

Five years ago the fund didn’t use passive investing at all. 

 

Poba is far from an outlier. ETFGI, a research provider that tracks ETFs, noted that Asia Pacific-based ETFs had $115 billion of assets at the end of 2015, but this grew to $283 billion as 2019 drew to a close. 

That volume is a rounding error in the global total of approximately $6.12 trillion, but Asia Pacific is the fastest-growing area. And it’s important to note that regional investors frequently use ETFs based in different regions. 

 

Geir Espeskog, head of iShares Asia Pacific distribution platform at BlackRock, says the world’s largest fund manager now operates $132 billion for regional clients in ETFs, up nearly threefold over the past five years. “That is 90% to 95% from asset owner clients,” he said. 

 

Plus asset owners invest even more through index funds that they get even more cheaply from fund houses.  

 

“There’s a lot of runway for growth in this region; $132 billion [in Asia Pacific assets in ETFs] is big but it’s small relative to the total business size,” said Espeskog. 

 

The impact of the coronavirus could only serve to underline these issues. While the stock market drops that took place during February, March and early April have reversed somewhat, the underlying economies continue to struggle, and look set to do so for much of the year. Further stock price falls look extremely likely. 

 

In these conditions it's likely that most active equity funds will continue to find it very hard to outperform volatile markets. While some active managers should cover themselves in glory (or at least defy gravity to a greater degree), most will probably reveal their inability to outperform benchmark indexes during times of existential difficulty. 

 

Covid-19 may well end up only underlining the to asset owners the practicality of increasing their use of passive investing – at least for large portions of their mainstream asset portfolios.