Passive investing: smooth sailing or storm ahead?

26th June 2017

Erika Mesmer, Client Relationship Manager

At IAM, we strongly believe in active asset management, allowing us to choose quality investments and so generate strong long term investment results for our clients.

Passive investment has however characteristics, which appeal to many investors: it is easy to understand and implement, the investor participates to the market and these strategies come at a cheap price. The performance is also very predictable, as it is the performance of the underlying index less costs.

All these factors have led the passive market, especially the ETF market, to grow rapidly over the last decade. While assets worldwide invested in ETFs at the end of 2006 represented USD 566 billion, volume has multiplied by six, to reach USD 3422 billion at the end of 2016.

This massive increase in equity ETFs is also the result of the current low interest environment, where many asset classes, especially bonds, do not generate the returns they historically did. Hence investors are shifting their money to an investment strategy, which has offered significant positive returns over the last years, based on rising equity markets.

This has in turn contributed equity markets as a whole to rise based on the demand for this asset class. However there is a lack of differentiation between the valuation of good companies and weaker ones. Or expressed differently, best possible wealth creation is prevented as capital allocation is far from optimal.

More and more voices in the market are now raising concerns of the consequences of this huge move to passive investment. Governance issues are one, as a few large ETF providers control a steadily growing portion of the market. Corrective market movements, which have always been much shorter and fiercer than rising movements, are now even more likely to become extreme and damaging. An investment decision can only be on or off, sell all or hold all, as the strategy does not allow for any distinction. In such an environment, when many seek to sell, willing buyers will most certainly become selective and favour quality stocks, with solid underlying fundamentals – the correction for weaker companies will therefore be even more painful.

As cautious investors we therefore strongly believe in the importance of investing, at all times, in solid quality companies and so to have the ability to choose to invest in a company – or not.