Beware the Risk of Peer Pressure and Passive Investing

Is the fear of something new combined with a fear of risk hurting returns when investors need them most?

(September 27, 2012) — Institutional investors have been reducing their return-seeking assets and moving to derisk portfolios, but a fear of high fees, being the first mover on a new idea, and short-term thinking could mean they are putting themselves in more danger.

Over the past five years pension funds in the United Kingdom have reduced their return-seeking assets from 65% to 55%, according to the consulting arm of accountants and auditors PriceWaterhouseCoopers (PWC).

This move has come despite pension fund deficits in the corporate and private sectors rising and remaining close to historically high levels.

Jeremy May, a partner in the division at PWC, told aiCIO that this was due to pressure on investors from the national Pensions Regulator to remove risk from their portfolios, and advice to executive boards that maturing funds should hold less risky assets.

“Pension funds are looking at self-sufficiency targets of 20-25 years,” said May. “This means they are moving out of risk assets to more matching ones – this does call into question where the active management industry will be in a couple of decades’ time.”

During the height of the crisis, billions of dollars, euros and pounds of institutional assets were shifted out of actively managed funds to passive instruments due to investors’ reluctance to pay relatively high fees for losing money. These instruments, which track a particular market, were also seen to be less risky due to the all-encompassing approach and often a lack of complex strategy. 

Although there has been a trickle of assets returning to active management, ETFs and other tracking vehicles remain popular with investors.

Laurens Swinkels, vice president at Robeco and assistant professor at the Erasmus School of Economics in the Netherlands, cautioned investors of hurrying out of perceived risky assets without a proper strategy to gather necessary returns.

Swinkels told aiCIO: “The crisis has shown that passive investing has risk too – people that follow the market are also taking on risk – there are smart ways around it if people are willing to listen.”

Swinkels is an advocate of low-volatility investing and taking a factor approach to constructing portfolios. Using these tools, he says, investors can take the upside of investing in risk assets, but avoid much of the downside usually associated with them.

“Using factor premiums should be done through strategic allocations – not just allocating to a selection of equities and bonds – investors have to look at the value and growth aspects of asset classes and only then move to the manager selection process,” said Swinkels.

Blindly allocating to passive investments to try and lower risk is an incorrect approach, according to Swinkels.

“Exploiting these premiums naively means an investor is exposed to unwanted risks. Smart implication is the key.”

Since the onset of the financial crisis, Swinkels said investors have been willing to look into strategies that had only really existed in academia, such as factor investing. He said people were more willing to entertain the idea, but there were still plenty of investors making a call based on plain equity and bond performance without digging any deeper.

In a strong bull market, this strategy may fall behind other active strategies, but this should not be a sustained problem, claimed Swinkels. “You need to make a substantial allocation to this strategy and move away from holding so much market risk, but unfortunately if the strategy underperforms for four or five years it is enough for the person making the decisions in the fund to lose their job,” he said. “We need to take a longer-term view and realise that occasionally lagging peers on a short-term basis can mean better returns overall.”

May said a push into fiduciary management by pension funds was increasing the level of portfolios taking on more sophisticated approaches to risk and investors were realising that there were a large number of asset classes where value could be added through active management.

“Many pension funds have thought about strategy [in their portfolios] and want good ideas to eke out value and find opportunities,” he said.