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Q: How will the economic downturn change the debate of active vs passive when it comes to investing? 

Passive investing is a strategy that seeks to track or mirror a market index rather than beat it.  In contrast, active investing is generally a strategy focused on trying to beat the performance of the market. 

The downturn associated with Covid-19 is very different from a ‘typical’ cyclical downturn. The fates of companies and, indeed, entire industries are currently being determined by the social distancing rules laid out by governments – as well as rescue and stimulus measures designed to soften the devastating effects of such rules. 

In this environment, stress-testing of companies’ balance sheets and their access to secure lending and state aid is crucial. Conversely, relying on characteristics that sit well with passive strategies and which often include backward-looking definitions of financial health could get investors in trouble. 

There is a very valid argument that such issues are only temporary, and long-term investors should continue to focus on the long-term growth prospects.  

However, those prospects may never materialise if a company is unable to survive the next six months, and this likelihood of survival is not something a passive strategy can credibly evaluate. In this case, active management can help cushion the downside in a prolonged downturn by shielding investor portfolios from some of the worst outcomes.  

The key here is for fund managers to stay adaptable and not to model the outcomes of the current crisis on those of previous ones. Navigating a road with the false confidence of an old map is even more dangerous than with no map at all.  

The downturn associated with Covid-19 is very different from a ‘typical’ cyclical downturn (Photo: Onurdongel/Getty)

Q: What does this mean for the future of passive investing? 

We do not suggest the Covid-19 crisis will reverse the investment industry trends observed over the past decade or so, which has seen the passive investment market grow. Whether large-scale vaccination programs succeed or social distancing becomes the new normal (most likely, a combination of the two), financial markets will eventually settle.  

Indeed, by the end of 2020 many sectors fully recaptured losses sustained earlier in the year and even reached new highs.  

New alternative data sets prompted by the pandemic will make their way into passive rule-based strategies, erasing any competitive advantage gained by managers that take an active approach to investing. Meanwhile, investor focus on costs, competition among providers and research advances should continue to support passive strategies.  

We employ both active and passive strategies when constructing portfolios and expect to continue to do so going forward. 

Q: Should passive investing be even cheaper? 

If passive investment is to survive, it’s likely it will need to become more sophisticated and cheaper in future. 

At one end, a group of entrenched industry players have been using their scale and technology to race to the bottom when it comes to “vanilla” Exchange Traded Funds (ETFs) on mainstream indices such as the S&P 500, bringing fees down to a few basis points.  

At the other end, smaller players are touting increasingly sophisticated screening to track niche passive products, such as medical technology and cryptocurrency firms. It is not uncommon for these to charge fees rivalling active funds. But there are insufficient live track records to prove whether net returns are worth paying for, so a careful evaluation is needed. 

Q: During a crisis like Covid-19 when markets are especially volatile, active strategies should in theory outperform more. Has this been the case? 

 The crisis related to Covid-19 unfolded differently from a typical cyclical downturn, with many finding themselves in unchartered territory. The worst weeks of the crisis were really challenging for active managers as investors rushed for the exits by selling up.  

Later on, as central banks started massive liquidity injections, we saw similarly indiscriminate moves in the other direction. Ironically, the same expensive sectors that led the market before the crisis, such as technology and staples, were the main beneficiaries of the lockdown, compounding woes of already underperforming active funds.    

Funds within the broad “sustainable” category have also been notable winners, driven both by continued investor interest in environment, social and governance (ESG) issues. 

However, we would argue that it is the aftermath of the crisis that gives stock pickers a chance to prove their worth. We saw this during the global financial crisis of 2008. Once the dust had settled, patient managers were able to go bargain hunting and delivered strong results in the years that followed, despite initially underperforming.