Why there's no such thing as passive investing in multi asset

Trevor Greetham, Head of Multi Asset at Royal London Asset Management, discusses how active management can help build portfolio resilience in a new era of geopolitical risk.

The rise of passive investing

One of the most striking changes in fund management over the last few decades has been the inexorable rise of passive investing. What started as a convenient way to access a diversified equity portfolio at low cost has broadened. An entire industry has grown, offering simple risk-targeted ‘balanced’ portfolios that automatically rebalance passive stock and bond allocations to preset weights.  

These solutions make sense in a world in which stocks and bonds only ever go up. But that’s a major call to make against the backdrop of the most expensive US stock valuations since the dot com bubble, a disruptive US President upending the world economic order and inflation fears dogging the bond markets.

In our view, the return of macro volatility makes the broader diversification and responsive management to be found in active multi asset portfolios more important than ever. 

Passive approaches are still an active decision

There’s an undoubted attraction in not having to assess manager skill when choosing an investment solution and making the choice primarily on the basis of cost. However, anyone recommending a passive balanced approach is in fact making four important active decisions that may or may not pay off:  

1. “Stocks and bonds are the only two asset classes worth investing in.”  

Broader diversification, including commercial property or commodities, can improve risk-adjusted returns. Unlike Bitcoin, these assets have been around forever, so there’s plenty of data to support this view.

2. “Bonds always diversify equities.” 

This assumption is called into question by the stagflation shock of 2022 when stocks and bonds both lost investors money. True diversification that year came from commodities. 

3. “Rebalancing to fixed weights is the best way to control risk.”  

Business cycle analysis suggests otherwise. Each asset class has its time in the sun.

4. “Nothing is to be gained from security selection.”  

But passive strategies also use security selection, always investing most in the largest and most expensive stocks – a painful experience when valuation bubbles burst. 

Active management key in uncertain markets

Cost matters, especially when compounding returns over the long run. And it’s natural that it becomes an increasingly dominant driver of strategy selection the longer a bull market goes on. Why pay for an active manager, the argument goes, when the market is great and you can get those returns almost for free? But this is looking in the rear-view mirror and we face an uncertain future.  

There’s a lesson from the 1970s when the post-war boom dominated by ‘Nifty Fifty’ mega-cap growth stocks came to a shuddering halt amid geopolitical stress, oil shocks and economic malaise. Gilt and US Treasury yields peaked at over 15%, causing stock markets to de-rate aggressively. Neither asset class kept pace with inflation

Cheap valuations provided fuel for the long bull market in stocks and bonds that followed. Inflation dynamics changed dramatically for the better over the 1980s and 1990s as the fall of the Iron Curtain brought significant commodity capacity onto world markets and China became the workshop of the world. 

Formal inflation targets became the norm, with independent central banks willing to raise interest rates to counter inflation. Bond yields set lower lows with every business cycle, with developed governments seeing 10-year yields trough between minus 1% and plus 1% around the time of the Covid-19 lockdowns in 2020. Equities enjoyed strong returns over this period, with infrequent recessions and bear markets, and valuations expanding as discount rates fell. 

Does history repeat itself?

It's hard to argue we’ll see the same again over the next decade. The cyclically adjusted price to earnings ratio for US equities was below 10x in 1981. Today, the same measure is 37x, a level only previously seen before the 1929 stock market crash, during the dot com bubble of 1999/2000 and just ahead of 2022’s bond-induced bear market. 

Expensive markets can get even more expensive in the short term, of course, but as the chart below illustrates, valuation is the best predictor of medium-term returns. While lower valuations are available elsewhere in the world, a passive buy-and-hold equity strategy weighted heavily towards the US may not end well.