While typically considered benign, passive index investing can come with unintended consequences.
At the 2020 Berkshire Hathaway annual meeting, Warren Buffett remarked: “In my view, for most people, the best thing to do is to own the S&P 500 index fund”.
For many portfolios, a core passive allocation to a particular market, or segment of the market, is likely to be adequate if the investment horizon is sufficiently long. After all, the probability of a positive 10-year return for the S&P 500 is 94 per cent over the past 96 years, versus 73 per cent for a one-year investment horizon.
Passive strategies can also be a low-cost way for investors to access “beta”, or get exposure to the long-term compounding benefits of investing in a particular asset class, such as US equities.
But with the top 10 stocks in the S&P 500 accounting for more than 30 per cent of the index, even a passive allocation should be viewed for what it is: a very active decision to maintain an aggressive weight to the 10 largest companies in America. Given this concentration, investors should carefully consider the implications for their portfolio construction when blending passive and active strategies.
More importantly, investors must also acknowledge that, just like investment returns, investment styles are not persistent. Market regimes can change, potentially leaving a portfolio vulnerable if it skews too heavily toward one approach, particularly a passive one.
Shifting sands
One logical approach for investors to take is benchmarking, or measuring the performance of their portfolios. While passive investing has surged in popularity recently, benchmarking to an index is far from new.
Index funds are based on the efficient market hypothesis, which suggests that all available information is already reflected in share prices, making it difficult for active fund managers to consistently outperform an index.
For that reason, index funds offer a simpler – and often cheaper – investment option for many investors; however, what is often overlooked in the rise of passive strategies is the way they subtly shift the primary goal of investing.
Outperformance under the microscope
Many investors will claim that capital preservation is their overarching concern, with compounding returns a secondary consideration.
The notion of loss aversion – a cognitive bias where individuals feel the pain of losing money more acutely than the pleasure of making it – suggests that capital preservation ranks foremost in investing principles.
But, combining a capital preservation philosophy with a benchmark-aware portfolio can be inconsistent.
A benchmark-aware portfolio is one where the performance of investments is closely measured against a specific market index, with the goal of outperforming that benchmark.
While this might sound prudent, it can be misleading. For instance, if the primary objective of a fund manager is simply to “outperform the benchmark”, and the benchmark drops 20 per cent while the fund only falls 19 per cent, the manager has technically achieved this goal.
The manager is credited with having “added alpha” – a supposed success, even though the investor has suffered a 19 per cent loss in capital and is left significantly poorer.
Consequently, the first principle of the client’s investing framework – capital preservation – has been violated, and in some cases, severely so.
Measuring downside risk
Given the propensity for bull markets and all-time highs to coincide with higher levels of complacency, investors would be well served to brush up on an often-ignored facet of manager selection – the downside capture ratio.
The downside capture ratio is a measure of a portfolio’s relative performance in down markets (defined as a period of months or quarters when the market return was negative).
For example, if a portfolio has an 80 per cent downside capture ratio, then
historically when the market was down 20 per cent (the definition of a bear market), the investment captured 80 per cent of that and was down 16 per cent.
Why does this matter? Because compounding works both ways and is asymmetric – excess returns on the way down are worth more than excess returns on the way up.
Point for point, excess return from downside protection is far more powerful than excess return through upside participation.
For instance, the difference between a 16 per cent and 20 per cent loss might not seem large, but for a 20 per cent drawdown to recapture its value, the portfolio must rebound 25 per cent, versus 19 per cent for a 16 per cent drawdown.
Again, this may not seem significant, but over the past 20 years, the rolling one-year return for the MSCI All Country World Index exceeded 25 per cent less than 8 per cent of the time, but it has exceeded 19 per cent more than 18 per cent of the time.
The probability and time frame to recover from a 16 per cent drawdown is significantly better than that for a 20 per cent drawdown, despite the seemingly small difference between the two.
Investor beware – and be aware
To put it bluntly, for investors fully allocated to a passive, or benchmark-aware investing philosophy, the downside capture ratio is effectively 100 per cent – that is, they absorb the full extent of the downside.
And importantly, the onus is on investors to pick (and stick) with managers that have consistently delivered over time, noting that active manager returns can also vary widely.
Regardless, it’s important to remember that keeping up with Joneses in good times can leave investors with a much bigger mountain to climb in bad times.
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