The index craze remains in full swing. At the end of June, the mutual fund industry was 34% passive, up from 30% at the beginning of 2015. In the US Equity category, that number is now 43%, up from 38% according to data from Morningstar. With the exception of some net rotation into other categories, outflows from active funds have simply moved across the deck into their passive counterparts. There are valid reasons for this trend. Indexing has been a consistent top quartile performer over three, five and ten year periods and lowering fees makes sense in a low return environment. The prospect for increased regulation and litigation also puts the rationale for using more expensive products under increased scrutiny. And the pace appears to be accelerating and it is not unimaginable that the fund industry will be more passive than active in just a few years. But history shows the pendulum often swings too far, bringing the potential for unintended consequences.
The role of risk management
While the industry has been busy with fee re-positioning, less attention is being paid to managing risk in the portfolio, particularly at this stage in the cycle. After nearly 8 years of watching a basic 60/40 benchmark portfolio trounce more diversified portfolios, some are concluding that this cycle is truly different and fighting the Fed is foolish. If that’s the case, indexing is likely to keep winning as the tide will continue to raise all boats and fees will be the differentiator between top and bottom performers. Under this scenario, a passive approach to managing risk (which asset allocation is) may work fine.
Robo advisors will surely follow this script and construct portfolios consisting of static allocations to indexes (perhaps with annual re-balancing) and rely on historical correlations (which have been decaying for years) to control risk. While this reflects a level of sarcasm, it also reflects the realities of scale and regulation. Besides, if a Robo advisor’s moderate growth portfolio falls 30% (as the 60/40 portfolio did during the financial crisis), the 25-year old making contributions to their 401-k will be ok because volatility is often beneficial during the accumulation phase.
Cookie-cutter advice and the retiree
But for a retiree beginning to take distributions, hitting a bear market out of the gate can spell disaster because the sequence of returns now matters greatly. For those investors, a strong case can be made for a more active approach to managing their portfolios, including defining a risk range and adapting exposures as risk levels (and risk premia) change. But, this requires skill and effort and, frankly, in a more litigious world it may be easier to just go with the crowd (and past convention) and build low cost, ’optimized’ portfolios based on what’s worked in the past. Advisors who reject “conventional thinking” will be justifying their fees and poised to grow their practices. Likewise, asset managers who transition their field force from product specialists to portfolio consultants will have a seat at the table with these advisors. For others, indexing and fee compression may be what meteors were for dinosaurs.