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Rise of passives

What happens when we hit peak passive? Rathbones head of multi-asset investments David Coombs wonders how markets will look when dumb money outnumbers the people looking at the accounts.

6 June 2019

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Article last updated 19 February 2023.

Tracking indices has become a popular way of investing in the past few years. Quantitative strategies have also been on the rise.  That’s where computers are let loose to read news reports, old price data and relationships between assets and then trade on their inhuman hunches thousands of times a day. Both have had profound changes on markets. Momentum, as a factor, is supreme. And a wave of passive investors buying stocks based on how much they went up yesterday has no doubt played a part in that. There are other effects. To us, at least, it feels like assets get lumped together for superficial or artificial reasons much more frequently and to a greater degree than in the past. We reckon this could be due to the multitude of funds that simply track a basket of stocks put together passively to suit a certain theme (usually cooked up by investment bank research desks). It could be all UK stocks moving as one, even though few of them make much cash in the UK: let’s call it a ‘Brexit basket’. Or perhaps any business with half a hand in Artificial Intelligence or automation is bundled together as a ‘Next Gen’ ETF. It means the prices of all those companies start to become more correlated the more people buy into the story. And there are a lot of these stories around at the moment – with ETFs to ‘play’ them.

Nowadays, one telco posts poor results and every company with some masts seems to sink along with it – sometimes even the shipping companies! This creates problems, but it also creates opportunities for the patient investor. When a whole sector is sent lurching downward because a competitor’s bad result snowballs into a mass sell-off by quant and passive funds, active fund managers can buy the quality companies at a much better price. When you’re taking the long view, you can ignore some short-term confusion; passive investors and quants can’t.

These dynamics are only going to increase in the coming years, we believe. As the amount of passive and quantitative trading gets closer to matching that of active managers, markets could start to look very strange indeed. At the moment, most trades are active ones, compelled by company fundamentals like honest earnings, prudent borrowing and sustainable growth opportunities. When passives and quants take the lead, the underlying financials of a company may have less significance for markets. Companies may start to adjust their financial accounts to manipulate specific metrics that passives and quants use blithely to determine what to buy. As soon as discretion is removed from decisions, things tend to go awry.

 

It hasn’t always been easy going, but Rathbones’ multi-asset strategies have come a long way since they were first launched a decade ago, and David Coombs, our Head of Multi-Asset Investments, takes the opportunity of this 10-year anniversary to reflect on that journey in his report 'Cracking on'.

 

Visit our 'cracking on' hub.

 

 

 

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