It is clear to me passives are more at risk from a bear market. Central to my thinking on this are two fundamental issues.
Firstly, there is the dominance of several well-known US companies that are going to feature heavily in any passive portfolio — especially one constructed using the market capitalisation of each of the world’s major markets to determine geographic allocation.
That matters because as Financial Times columnist John Plender points out: “A downturn will expose the extent to which investors in passive funds have been giving insufficient attention to diversification, liquidity and risk control."
So, a lack of diversification, liquidity and risk control: enter the so-called “FAANGs”.
These companies include Facebook, Apple, Amazon, Netflix and Alphabet’s Google. All technology companies, they constitute a huge 41 per cent of the Nasdaq and over 10 per cent of the S&P 500 index.
Investing in the indices to get exposure to these companies on the way up has been great. But many clients might not be so happy if there is a repeat of the collapse of the 'Nifty Fifty' which occurred in the long bear market of the 1970s.
These were deemed to be 'one decision' stocks; they were to be bought and never sold, and were born out of the optimism of the 1960s and a belief that US industry could dominate the world.
At the height of the index the price to earnings ratio of the most expensive four stocks were:
- Avon Products 65
- Walt Disney 82
- McDonalds 86
- Polaroid 91
The S&P 500 then stood on a P/E of 19.
Each of the Nifty Fifty were then on a P/E of 42. In the 1970s bear market they fell in value by two-thirds.
Of course, many active managers also hold the FAANGs, as to avoid them could lead to woeful underperformance. But unlike a passive holding of the index, an active manager can reduce allocations if circumstances dictate, which can help preserve capital.
Judgements made by man, rather than machine, might be a positive influence in these circumstances, especially in a scenario where the strength of a company’s balance sheet might determine its ability to survive a long recession.
I prefer the strategy adopted by many advisers of buying equity income funds rather than index-focused passives for equity exposure.
The argument behind this is a good equity income fund is stuffed with 'steady Eddie' businesses that pay their dividends through thick and thin.
These companies are often utilities, breweries and tobacco companies. Importantly, these types of firms are thought to be recession-proof companies that will hold up well in the event of a market crash.
While this strategy definitely has some merit, the composition of many modern equity income funds means investors must do their research carefully.
Stock concentration can be an issue, as has been shown to be the case recently with the hit suffered by star manager Neil Woodford following the crash in Provident Financial shares. Many funds now focus on small cap companies, and FTSE 350 constituents are all commonplace; certainly, no guarantee of lower volatility.
So what do we do at Hunter Aitkenhead & Walker? Well, we run three model portfolios.
We had these all back-tested to compare performance using our historic (changing) asset allocation, assuming the portfolios held 100 per cent passive investments, with the odd exception, such as commercial property.
The hypothetical passive, cautious and balanced risk portfolios turned in identical performance after charges, compared with the real-life active portfolios. However, the volatility was higher in all cases.