The reasons are clear – they are cheaper than most active strategies, people feel they know what they are buying and often the relevant target strategy can be hard for active managers to beat.

Not all is what it seems. This article will seek to demystify some of the hype surrounding these “passive” strategies and to highlight that while they are “passive”, it does not mean that they are without risk of disappointment.

It is important to first understand that they are typically based on the market value of companies.  The largest companies in the index are the largest ones in the portfolio. This means you can end up investing proportionately more in the largest market capitalisation and most expensive companies and can potentially also have larger exposure to industries that than is reflected in the real economy.  Reduced to its simplest a market capitalisation strategy simply keeps investing in the biggest companies regardless of their valuation. At some point this valuation may become too stretched and therefore dangerous to keep investing. A passive strategy will not care about the valuation of the largest companies but merely keep investing any subscriptions. Consequently, they may be anything but “calm and safe” as the word passive may imply?

The actual volatility, or the price swings, of an index fund may be very high especially if it has high weightings in just a few stocks.  For instance, at 31/5/2017 the 20 largest companies in the ASX300 represents 54% of the index market capitalisation. If the largest companies share common business models and an event occurs, then the share prices of all will move together.  We highlighted recently the similarity of the Australian banks and how their share prices moved together more than any other bank sector.

Passive or “index” funds have also been shown to underperform certain investment styles like Value or Growth or “Quality”– where an active fund may focus on lowly valued companies or high growth companies. Investment managers have attempted to replicate exposure to these investment styles through what are commonly known as “Smart Beta” funds.  These are becoming increasingly sourced through Exchange Traded Funds (ETFs).

While they appear to be better than simple market capitalisation weighted index approaches, they also contain risks of which investors should be aware. To keep costs down and to pass the test of being an ETF the “investment rules” that define these style portfolios are often very crude and simplistic. Using low Price to Book value ratios to select the preferred stocks in the ETF, for example, will give a Value tilt but the tilt will come without any regard to the risk of the aggregate positions. The crucial difference between an index or “smart Beta” passive approach and a portfolio is that the portfolio should be designed to maximise return while managing the risk. The standard “smart Beta” indices do not manage the risk of the $ invested but only select stocks in weights which reflect their style exposure. “Smart Beta” makes dumb portfolios.

We can explain this with an analogy. We use the analogy of shopping for food in a supermarket. Let’s say that you have to shop for food to prepare dinner. You know what dinner should look like – a sensible mix of the food groups. This sensible mix we can call a portfolio. It is optimal like a portfolio in that it will meet a number of criteria not just meet a certain tilt to price. A “smart Beta” approach to shopping for dinner would be to look for the ingredients on the basis of price. A certain $ budget would be allocated and the shopping basket (or stocks) would be selected only on the basis of price to weight of tin or price to quantity of food. You would get some ingredients that are specifically suitable for your dinner menu, but it would not be exactly what you want. A portfolio management approach would use price as an input BUT ALSO try to optimise the ratio between price paid and the amount of the specific food item to make up the dinner ingredients. The portfolio management shopper would perhaps pay up for an ingredient that was essential to diversify the other items on the menu? The portfolio management shopper should look to get a more appropriate mix of the ingredients in the basket and care about price AND relative weights to make dinner.

Like so many things in life, there is always a risk when things get too popular and so much money pours into particular strategies. Those stocks that are in indices, be they simple market cap weight indices or a crude Value or Growth fund can get pushed up too far due to the sheer weight of money going in to them, whilst those stocks lowly considered or outside these indexes or style benchmarks can become neglected and potentially undervalued.  These neglected stocks may potentially be more attractive investments going forward as is the case now – we believe.

For example, in the USA this year there has been a big focus on Growth / Momentum stocks which has meant most of the market rise can be accounted for by the movement of just a few stocks – Facebook, Amazon, Apple, Alphabet (formerly known as Google) and Netflix. The last time we saw this kind of rise was in 1999 in the USA Tech bubble.

Many of these Smart Beta strategies are currently perceived to be the new “holy grail” of investment management.  The limitations of these investment approaches may only become truly apparent after the event.  We have only to think back to the Tech boom bubble in the late 1990s and the ultimate bust of so many dot com companies in the fall out of 2000-2 to see the dangers of fashions in investing.

So, the advice is to look behind the shiny wrappers and bold claims and try to see how intelligently these strategies have been put together. What empirical evidence there is to support these approaches, and whether these trends are likely to continue?

Importantly, it is important to understand how the strategies operate and not get caught up in purely mechanical and computer driven investment approaches just because their current performance is good.  Recognise that all investment decisions involve judgement and experienced people are required to manage a portfolio, not just a set of rules.

We like to use two famous quotations when we describe our process which seeks to use quantitative or computer driven models but only with a human being in charge.

“Not everything that can be counted counts; and not everything that counts can be counted”

“I would rather be approximately right than precisely wrong”

Recently Warren Buffett made headlines across the globe by reminding everyone of a bet he made nine years ago. That bet was that any set of five hedge funds could not beat the S&P 500 on a ten year basis.  At the nine year mark, Buffett is comfortably ahead. Consequently this kick-started a debate across the globe around the efficacy of active versus passive management which has been raging ever since.

​In Australia, we believe this debate needs to delve further. The construction of the Australian benchmarks means index investors are taking concentrated bets and worse than that, so called active managers are running portfolios by massaging around these bets. This is due to an index that is top heavy and concentrated in a number of sectors. To illustrate this point we can compare the largest holdings in the S&P 500 to the ASX 200. The top 10 companies in the Australian index have a combined weight of 43%, whilst in the US its 19%. When we look at the top 20 companies in Australia they represent 56% of the index versus 28% in the US.

In buying the Australian index you therefore take a concentrated exposure in twenty companies with a long tail. The greater problem comes when you start to delve into the composition of those twenty companies and you find:

• The four largest companies (the banks) representing 25% of the index essentially do the same thing. Whilst the big four banks do have subtle differences, a majority of their profits come from residential mortgages. In addition, all four are currently being hit by increased capital requirements and additional levies.
• A supermarket duopoly that has been disrupted in recent years by low cost entrants.
• A former national Telecommunications company that has seen most of its competitive advantages disappear in recent years.
• And a high exposure to highly cyclical commodities markets.

When we compare the Australian index in totality to the US index we can see these concentration problems arise. The two largest sectors in the Australian market (financials and resources) represent over 50% of the weighting whilst in the US it is 37%. Buying a passive index fund in Australia means you are betting over half your capital on the Australian housing market and commodity prices, most notably Iron Ore, LNG, Gold and Coal. In the US, the two largest sectors are Information Technology and Healthcare, the two fastest growing sectors globally in recent years.

This all brings us to active management and here lies a major issue for Australian investors currently using managed funds. A lot of the tools used in portfolio management have the benchmark (in this case the ASX 200) as a starting point. Active fund managers will manage to a targeted tracking error. In layman’s terms, tracking error is a statistical measure of how far you differ from your underlying index. Due to this constraint, active funds will usually have limits to how far they can differ from the index by sector.

To illustrate this point we had a look at the most recent quarterly report from a well-regarded Australian Equities manager with a growth focus. The top three holdings within the fund were Westpac, CBA and NAB with a combined weight of 22%. Given the growth focus of the manager it is surprising that their top three holdings reported Cash Earnings per share growth of 1%, 0% and 2% respectively at their most recent results. In addition with payout ratios above 70% and a regulator enforcing stricter capital limits, these banks have little capability to grow any time soon. Now, this fund manager would most likely tell you they are “underweight” the big four relative to the market weight, as it seems fairly clear that they are unlikely buying these shares for their earnings growth.

The most likely reasons they own the shares is twofold:

1. Their above mentioned tracking error budgets and portfolio restrictions means their process will force them to buy the banks.
2. Career risk, if an analyst or a fund manager took a significantly negative position against a sector of such great concentration and was to get it wrong then they would most likely be looking for a new job.

As a result, active funds in Australia tend to have the same concentration risk as the underlying benchmark. An investor seeking to invest will end up with similar problems if they were to go through a passive fund or an active one. If the banking sector falters, investors in either camp will suffer. To see how this would play out over time, one only needs to look at Japan. If you were to go back to 1993, the banking sector was almost 20% of the Nikkei; it is now sub 10%. The Nikkei over that time on a price basis has gone up by only 12% (or 0.5% annualised) and the banks have been a key drag.

Obviously, Australia is different than Japan with one of the key distinctions being immigration but the example does highlight the risk associated with concentrated indexes. Whilst Japan has been largely considered an investment disaster due to an index that has barely moved over the last 25 years, the structure of the index has changed considerably during that time. The banking sector has detracted whilst other sectors have grown, most notably sectors such as technology and global consumer focused companies.

In Australia, it isn’t hard to envisage a similar scenario in the future. Ultimately in ten years’ time it is unlikely that the banks will have the weight they currently do. The pressures of record household debt and increased regulation will likely weigh on their performance.  On the other side, Information Technology currently makes up 1.8% of the index and we’d be worried for the Australian economy if this wasn’t significantly higher over time.

Quite often we get asked our opinion on where the Australian market is heading and we give our honest answer, we don’t know. What we do say with some confidence is regardless of index performance we believe the sector mix will change over time. As a result we believe truly active management that ignores the index is the only way forward for Australian investors.

A few things stand out. Mortgages and small business loan rates have been coming down since April 1995 and we all know why. Disruptors such as Aussie Home Loans and RAMS forced the banks to start pricing fairly.

But, personal loans are basically at the same place as they were 20 years ago. This is during a period when default rates have been low and the economy has been strong.
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But the story is more interesting when we look at real returns to the banks on personal loans.

Real rates have actually gone up over the last 20 years. This is in the context of a generally stronger economic conditions and low default rates.

So let’s draw all this together. Term deposits are at historically low returns. More importantly, real returns on term deposits have come down consistently for the last 20 years, in some cases hardly keeping pace with inflation.
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In contrast, the real return on personal loans has been increasing giving the banks exceptional returns for the risk.

Until recently, access to the personal loan asset class was limited to banks and credit unions. Peer-to-peer lending gives retail investors the opportunity, for the first time to access this asset class.

In the USA and the UK, peer-to-peer lending has become very mainstream with over $20 billion dollars lent in 2016.

In a nutshell, peer-to-peer lenders match people looking to borrow money with people who have money to lend. Most peer-to-peer lenders have chosen to focus consumer credit and small business loans. Small loans like this allow greater diversification and lenders benefit from substantial data available to the peer-to-peer platforms which allow them to make informed credit decisions.

Leading peer-to-peer lenders, like RateSetter and Society One, target the top tiers of creditworthy borrowers. They compete against the banks (not payday lenders) for borrowers. Rates offered to borrowers are often lower than what that borrower would pay to a bank as peer-to-peer platforms operate more efferently than banks and pass on costs savings to borrowers and lenders.

There are two peer-to-peer models that have developed, one from the USA and the other from the UK.