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Challenges Facing Passive Investing

Declining liquidity and incrementally more sellers than buyers offer plenty of reasons to be more cautious and particular about investments.

By Dan Hughes

Passive investing has enjoyed several tailwinds throughout the post-financial crisis recovery. One of the most influential has been the expansion of global central banks’ balance sheets. In aggregate, the balance sheets of the world’s six largest central banks are approaching $20 trillion, essentially the equivalent of U.S. Gross Domestic Product.

The excess liquidity resulting from rapid global central bank balance sheet expansion is not flowing through economic activity in the form of loans to commercial industries or for construction activity. Rather, it shows up directly into the prices of risk assets and has a disruptive effect on price discovery as well as an easing effect on credit availability and volatility suppression.

These together have contributed to distorted stock market performance. As a result, many stocks have performed better than their fundamentals indicate. It has also allowed passive funds to deliver returns well above historical averages. 

Liquidity causes distortions

An incremental slowdown in or reduction of liquidity also have a negative effect. The U.S. Federal Reserve stopped its quantitative easing program several quarters ago, and has begun a very modest contraction of its balance sheet. The next step is when the European Central Bank begins to shrink its balance sheet, lifting rates abroad and causing rates in the U.S. to rise in concert.

When credit markets begin to normalize, there will be more stock price dispersion and increased market volatility. If liquidity becomes constrained, indiscriminate stock buying turns into indiscriminate stock selling, a significant shift in investor behavior will drive a real separation between passively managed index funds and actively managed stock funds. 

How demographics influence stock prices

The number of willing buyers for securities also influences stock price movements. Since the early 1980s, that’s been the Baby Boomer generation. Now, Boomers are transitioning from investing in the stock market to becoming net stock sellers as they tap retirement savings. 

As Boomers reach the age of required minimum distributions over the coming years there will be incrementally more selling pressure, rather than buying momentum, as it relates to price movements on a go forward basis. By the back half of the next decade, it is expected that selling will outpace buying in retirement accounts. 

Similar to liquidity, buying doesn’t need to go negative to affect stock prices. It just has to be less positive. Further, we believe stock valuations are already quite stretched and investors will be looking for reasons to book profits and pull back. Declining liquidity and incrementally more sellers than buyers offer plenty of reasons to be more cautious and more particular about investments. 

A separation between active and passive

The net results of shifting demographics and tightening liquidity depicts a meaningfully different stock market than that of the past decade. As both factors play an increasing role, there will be a real separation between stocks that are trading at levels that are warranted based on fundamentals, skillful management teams, and solid product bases, and those that have traded upwards purely based on flows. There will also be a separation between returns from passive index funds and actively managed funds with skillful stock-pickers at the helm.

Look at challenges ahead, not in the rearview mirror

Challenges will develop as liquidity declines and we move through 2018. Cyclicals and industrials—normally considered more defensive stocks—have already seen improved performance, but stock prices haven’t yet reflected their newly uncovered strength.

Unfortunately, investors tend to invest based on the rearview mirror. It’s easy to look back for the last three to five years at an index that’s been compounded at a mid-teens rate and extrapolate forward. In reality, it is becoming increasingly more difficult for indices to compound performance at recent levels.

Successfully navigating these challenges—including the three D’s of debt, demographics and disruption—through skillful stock-picking will be required to generate attractive returns going forward.

Dan Hughes is client portfolio manager at Vaughan Nelson Investment Management

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