Index assault leaves markets intact for active managers

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by David Chaplin

The meteoric ascent of index-investing has yet to seriously distort financial markets and could, by contrast, spark new strategies for active managers, according to Mercer. In its thematic outlook for 2019, the firm says the investor index-rush has not, to date, cancelled out the ‘price discovery’ power of markets or created broader financial system risks.

“Although there may be pockets of concern, we have, so far, seen little evidence to suggest any investor action is needed,” the paper says.

Last year an analysis by the Federal Reserve Bank of Boston found that rampant passive investing had likely reduced liquidity risks while some index strategies increased market volatility.

The Boston Fed study also says passive investing has increased manager concentration (and therefore operational risks) while noting “mixed evidence” of price distortion for securities included in indices.

“Looking ahead, if index-inclusion effects, particularly price distortions, do become more significant over time, they may slow the shift to passive investing by increasing the profitability of active investing strategies that exploit these distortions,” the analysis says.

Likewise, the Mercer report says an increasingly passive investment environment would have pros and cons for active managers.

“A higher prevalence of rules-based investing may make the landscape for traditional active management even more competitive, but the potential returns available to skilled investors through exercising judgement may also improve if such rules-based strategies create systematic biases that can be taken advantage of,” the paper says.

“… Where active management may not be suitable for reasons of market efficiency, a broader spectrum of available systematic and alternative index strategies is likely to benefit investors not content with a portfolio construction process set out purely by an index provider.”

As well as the ongoing tussle between active and passive management, Mercer notes financial markets are facing other ‘winds of change’ that could blow investors off-course. For instance, the gradual withdrawal of central banks from emergency liquidity settings could stymie growth with listed markets – currently featuring “extraordinarily low yields and generally elevated valuations” – set to suffer the most.

“Private equity and private debt, on the other hand, have continued to offer attractive growth opportunities, and constraints on bank lending have also increased the opportunities for sophisticated investors to lend directly to businesses,” the Mercer paper says.

The growing enthusiasm for private assets could further dent the prospects for listed markets, especially in emerging economies.

Mercer covers a number of broad market trends in the thematic outlook for 2019, subtitled ‘The four elements’, including:

  • the emergence of ‘late cycle’ risks;
  • a structural change in “market participation”;
  • growing geo-political tensions; and,
  • the normalisation of sustainable investment strategies.

The report says the four themes, which will likely influence markets over the next few years, “are highly interdependent”.

– Investment News NZ

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