In modern history, we have never seen major national economies suffering such a sharp downturn at the same time as we are now.
The global economic shock of the coronavirus outbreak is extensive, and the scale and speed of the subsequent equity market falls have caught plenty of investors off guard.
Investors who typically track an entire index through passive exchange traded funds (ETFs) or index funds at low costs are exposed to the full effect of this market volatility, writes Julien Lafargue, head of equity strategy at Barclays Private Bank.
If an investor holds a passive ETF that tracks the S&P 500, for example, they have effectively taken the decision to own all the companies and sectors in that index. That includes owning airlines, hotels and energy companies at a time when these sectors are feeling the full impact of the pandemic.
It is a position which global investors of all kinds find themselves in, as passive investing has increased its market share, fuelled by a surge in the popularity of ETFs.
In fact, last year, the amount of assets in index-based funds and ETFs exceeded those in actively managed funds in the US for the first time.
Active vs passive approaches
The collapse in equity markets has raised questions about what investors need to be doing to shield themselves from losses, and where they can take advantage of potential opportunities, using a more active approach.
Active managers attempt to outperform the returns of a specific benchmark, using analysis, research and proven investment processes to make informed decisions.
In theory, they aim to protect investors from volatile markets, reducing the impact of market drops, while providing opportunities to outperform. That said, research suggests that many active managers struggle to do this successfully.
A genuinely active manager adjusts weightings to different companies and sectors of the market with the objective of delivering the best returns for investors.
Diverging reactions
In the current environment there have been signs of indiscriminating selling from some investors, driven by fear more than reason, but not all sectors and asset classes have reacted in the same way.
For example, some pharmaceutical, technology and retail stocks have in fact risen over the last month, while others have fallen only marginally.
On the other hand, some active managers merely mirror the market that their fund is benchmarked against, limiting the benefits of an active approach in bear and bull markets.
Each fund or strategy needs to be assessed to see just how active it truly is and therefore which have the greatest ability to effectively adjust to this new environment.
Unpredictable predictions
Research by Invesco in 2017 looked at 3,000 equity mutual funds over the past 20 years.
The research found that 60% of funds with a high active share – a measure of their difference to the index that they are benchmarked against – beat their benchmarks, after fees, across all market cycles studied on an asset-weighted basis.
Forecasting how the next few months will play out for equities through these national shutdowns is nearly impossible, but a lot will depend on how long such measures remain in place.
Some predictions suggest that US unemployment may temporarily jump as high as 30%, while some economists predict that UK GDP will contract significantly.
Market recovery on the horizon?
Encouragingly, while markets are expected to remain volatile, the bulk of the selling pressure may now be behind us, according to several market indicators including valuations, investor positioning and overall sentiment. It is more likely that we will see a U-shaped recovery in markets.
To navigate this period, a combination of active and passive strategies is likely to perform better over the longer term.
While some heavily researched and developed markets leave little room for active managers to add value, others, in the less efficient parts of the market such as emerging markets or small and mid-sized companies, are more suited to an active approach.
A mixed portfolio of passive and active strategies can be the most effective way to meet your investment goals, adjusted for their risk appetite, while balancing against the cost requirements of each.
This article was written for International Adviser by Julien Lafargue, head of equity strategy at Barclays Private Bank
