Two factors that have propped up passive investments are slowly fading away
Passive investing strategies have risen considerably in recent years, causing many investors to hop on the market-following boat. But with two driving forces set to fade away, it may be time for investors to abandon ship.
“Passive investing has enjoyed several tailwinds throughout the post-financial crisis recovery,” said Dan Hughes, client portfolio manager at Vaughan Nelson Investment Management, in an article for WealthManagement.com. “One of the most influential has been the expansion of global central banks’ balance sheets.”
Hughes noted that the balance-sheet expansion has led to increased liquidity, but that hasn’t flowed on to economic activity such as loans for commercial industries or construction activity. Instead, it has shown up directly in the prices of risk assets, which has disrupted price discovery, eased credit availability, and suppressed volatility.
“As a result, many stocks have performed better than their fundamentals indicate,” he said. “It has also allowed passive funds to deliver returns well above historical averages.”
But that tide of liquidity is set to ebb soon. The US Federal Reserve has stopped its quantitative easing program and is modestly contracting its balance sheet. The European Central Bank is following suit, which is leading to increased rates abroad. The upshot: more dispersed stock prices, a rise in indiscriminate stock selling, and increased market volatility.
Hughes added that the number of stock-sellers will also swell as baby boomers enter retirement. “Boomers are transitioning from investing in the stock market to becoming net stock sellers as they tap retirement savings,” he said. “As Boomers reach the age of required minimum distributions over the coming years there will be incrementally more selling pressure, rather than buying momentum.”
As buying behaviour and liquidity both swing into less-positive territory, investors will be looking for reasons to book profits and pull back. That means stock valuations that have been stretched for years are due for a contraction.
“[T]here will be a real separation between stocks that are trading at levels that are warranted based on fundamentals, skillful management teams, and solid product bases, and those that have traded upwards purely based on flows,” Hughes said. “There will also be a separation between returns from passive index funds and actively managed funds with skillful stock-pickers at the helm.”
