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Kiwis at risk of losing in passive investing “bubble”

15 October 2019

Global turbulence and increasing flows into passive investment funds supports “mega cap” stocks and amplifies the risk of passive investments, Kiwi Invest warns.

Simon O’Grady, Chief Investment Officer with Kiwi Invest, the funds management division of Kiwi Wealth, said Kiwis with a strong proportion of passive holdings in their investments, including KiwiSaver accounts and many Exchange-Traded Funds (ETFs), may not fully understand the level of risk they were taking on.

“We believe the best chance for investors to navigate these turbulent times is through an actively managed portfolio.

“Ten years of bull markets had led to a charmed run for passive funds, which many New Zealanders are exposed to via their KiwiSaver accounts and other investments. However, this performance has masked the risks of passive investing.

“One of the design flaws of passive index investing is their inbuilt tendency to buy more and more of the most expensive shares as they rise.

“With market conditions becoming increasingly volatile, the risk of a downturn means that passive investors are likely to be carrying higher risk. Of concern is massive inflows of money via passive funds into mega cap stocks (the largest listed companies). Many of these stocks are now quite richly valued and face the added risk of flows drying up, yet passive investors are still buying at a pace.

“Only active managers make an effort to assess the value of stocks and whether they’re worth buying. That’s why we’re constantly deliberating and considering our positions.

“Good portfolio design should always aim to create the best returns based on risk. To keep risk on target, that means taking a close look at how risk is spread across shares and a range of asset classes while actively adjusting exposure to the market through the investment cycle.

“That’s how money is managed smartly.”

Kiwi Invest is not the only fund manager raising concerns about the boom in passive investment.

Michael Burry, the American investor who warned of conditions leading up to the Global Financial Crisis and whose story was told in the movie The Big Short, says the focus of passive funds on mega cap companies puts downward pressure on the stocks of smaller companies, creating a “bubble” that could burst.

Kiwi Invest has just released its white paper, The Active Advantage: the case for having your money actively managed, which assesses the merits of active and passive investment strategies.

The paper found that while passive investment strategies had had a positive effect on lowering management fees throughout the industry, long-term performance was being compromised. The sole focus on costs, and the level of fee charged, left money on the table, said O’Grady.

“Passive investment strategies, with their sole focus on costs, miss out on a range of opportunities for adding value to long-term investment performance.”

The paper also warns investors of the rise of “closet indexers” – where unreasonably high fees are being charged for a low level of Active Share – and urges investors to ask questions of their fund manager to ascertain a fair fee they should be paying.

The white paper, including guidance for investors to determine how active their fund is, can be accessed here.

ENDS

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