While index investments have their place, it’s important to recognize what actively managed strategies can do for investors — especially in the current environment, where the risks embedded in passive strategies loom large.
Market surprises in 2016 underlined the difficulty in predicting what’s coming next. The long run of gains since the financial crisis that buoyed passive strategies may not necessarily be the arc of the future.
- Indexes may pose real risks. Indexes are not averages of the whole universe of securities in an asset class. Instead, they are models constructed around assumptions — many of them arbitrary — about what to include and how to weight it. Unfortunately, over time, those assumptions can introduce unanticipated risks.
Example: the concentration risk inherent in a cap-weighted index like the S&P 500, with the top 10 stocks accounting for over 18% of its value. But do those stocks represent the best chance for future gains?
- Some sectors are naturally suited to active. In specialized markets, where information is harder to come by — think small-cap stocks, emerging markets stocks, global high yield — active managers can add value by using their expertise to identify securities that are underpriced relative to their fundamentals.
- Active can preserve as well as grow assets. After fees, a passive index strategy will gain all that its benchmark gains — but also lose everything its benchmark loses. In contrast, active strategies have the option to adjust holdings in response to adverse conditions; indeed, the alpha generated by an active strategy can be traced to “downside capture” as much as gains from well-chosen securities.
At a time when valuations in many stock and bond sectors are historically high, and when rates may be poised to rise, active’s flexibility offers a measure of prudence as well as potential gains.