Has the drive towards passives reached ‘bubble’ phase? In this week’s Perspectives, Fund Manager David Jane looks at historic investment manias, and although they are based on a fundamental truth, how there is always a flaw in the argument.
Passives are the perfect answer to a question no-one ever asked.
Unarguable truths form the basis of all bubbles in investment markets, consider that the internet will change the economy immeasurably or the current AI bubble. These economic trends have and will play out, the flaw in the argument is to conclude from the known fact that certain companies that have been currently identified will be the ones to benefit. In the case of the internet bubble, it wasn’t Nokia or Cisco that really benefited, it was those that provided the products on the infrastructure these companies made. The same could be said of previous investment bubbles, the railways transformed the US economy, but it did not follow that the railway companies were the ones to benefit.
Hence all investment manias are based on a fundamental truth but there is always a flaw in the argument, typically at the point of implementation. In essence they are based on narrative arguments, stories. However, just because A is true B does not necessarily follow. As humans we are very prone to narrative arguments, it’s the fundamental basis of being human. As fund managers we have to put this aside, at least in the long run, and focus on factual reality.
There has been a relentless drive away from active management and towards passive and this is also based on a fundamental unarguable truth, the average active manager cannot beat passive. We wrote recently how the drive towards passives was making the market ever more driven by narrative and less by ‘fundamentals’. This trend may well remain for some time. This makes it ever harder for active managers focussing on building real value for the end client to beat indices. The drive towards passives may or may not have reach bubble phase, time will tell. However, we would argue that there is a fundamental flaw in this argument, as in previous fads.
The flaw in the passive argument is that end clients’ objectives are never to beat or keep up with some artificial index of investment securities. Their objectives are centred around such things as growing capital in real terms for a certain level of risk or growing income over time without impairing the real value of their investments.
This is where active management comes into play. As active managers we need to focus on delivering outcomes that passive cannot deliver more cheaply and efficiently. A classic example is retirement income. An active manager can build and manage a portfolio to deliver a predetermined level of income and growth within reasonable parameters. It is very beneficial to do this within a directly invested strategy and a collective scheme structure for so many reasons.
Progression of income and capital
Source: Premier Miton/Bloomberg, based on UK Sterling class B income units from 31.12.2018 to 30.09.2024. Total Value is on a total return basis to 30.06.2024 and is shown net of fees on a bid to bid basis with income reinvested. Charges taken from capital.
The level of income paid by the fund may fluctuate and is not guaranteed. Past performance is not a reliable indicator of future returns.
The Chart shows the evolution of the capital value and the annual income of £250k invested in our Premier Miton Cautious Monthly Income Fund since December 2018, assuming dividends reinvested. An example of real customer need. Over the past 5 years to the end of October 2024, the Premier Miton Cautious Monthly Income Fund has returned 26.61% compared to a return of 15.92% for the IA Mixed Investment 20-60% Shares sector.
The same is true for defensive strategies, those tracking equity and bond indices take no account of the real risk embedded in asset classes. If capital preservation is the objective understanding the risk embedded in the indices is the key to success. Consider 2022, when the risk of a major sell off in bonds was not taken into account by passive defensive strategies. No passive strategy can replicate an objective that is not defined by an index.
The drive towards passives may or may not have reached bubble phase, time will tell. However, we would argue that this is the fundamental flaw in the passive argument.
By focusing on end customers’ requirements, active managers can provide real value to clients. The mixed asset arena has, to some degree, been successful at this over the past years by focusing on building portfolios to meet certain risk/return requirements. When it comes to building portfolios for a defined level of income growth the challenge is quite different, here the whole portfolio will need to be directly invested and actively managed.
We think we need to change the terms of the active/passive debate. If your clients’ goal is to have as many FTSE’s or S&P’s as possible then passives are the way for them. If their goals are more nuanced and defined in terms of capital preservation, income or risk/return, we would argue they all are, then an outcome focused active strategy could be the answer for them. No client can spend FTSE’s in Sainsbury, they only take real money.
David Jane
Premier Miton Macro Thematic Multi Asset Team
