Alex Rolandi asks if index funds have a role to play in combating current volatility and whether coronavirus has revealed market imperfections.
Global indices have been hit hard since the outbreak of Covid-19 wreaked havoc in markets worldwide.
All MSCI indices were down by about 30% year-to-date at the time of writing as uncertainty continued and central banks and governments scrambled to mitigate the economic and social consequences.
Market volatility looks set to continue for the foreseeable future. In the words of Hortense Bioy, director of passive funds and sustainability research at Morningstar, “these are crazy times”. It is a sentiment echoed across the asset management industry and beyond.
With countries across Europe and elsewhere in lockdown, financial markets show little sign of settling.
“When you’re invested in a market cap index fund or ETF, you feel the lows as well as the highs,” Bioy tells Funds Europe from her remote workstation. “With index funds, there is no protection,” she says.
Research by Lyxor Asset Management found that mutual funds and ETFs saw outflows across the board throughout the week ending March 20. A separate, timely report by Style Analytics claimed that active managers have outperformed passive strategies during market downturns over the past 25 years. More than 1,000 actively managed US funds were analysed. Quality active managers not only beat passive investment during downturns, but their outperformance against the Russell 1000 index increased in relation to the scale of market losses.
“There are advantages to active funds during a downturn as they can keep some cash and, with that cash, when the markets go up again they can take advantage of that [and] buy companies where they see opportunities,” Bioy says.
According to Tatjana Puhan, managing director and deputy chief investment officer of ‘anti-benchmark’ manager Tobam, the current market environment “is one that calls for index fund investors to take caution”.
“In the equity space, the current market evolution exacerbates the massive bets that benchmark indices have built up over recent years, notably in the IT and communication services sector. Stocks in these sectors were much less sensitive to the sell-off and continued to increase their weights in the market indices because they were sold less,” she says.
And if passive investors are, therefore, buying baskets of highly sought-after stocks, they are taking a higher risk than they might realise.
Puhan, who argues that what is considered ‘passive’ investing is, in fact, just another form of active investing, says: “Like many other investors, a supposedly passive investor will do nothing else than buy high and sell low, but just using a different instrument such as an index or exchange-traded index fund.
“The passive investor has no means to avoid this from happening. Either the investor buys the basket of large bets or sells the basket entirely with a potentially significant market impact, or the experience of extreme drawdowns when the large bets start to evaporate. Markets in panic mode are consequently one of the biggest risks that can occur to a passive investor.”
So, as markets look set to be unsettled for some time to come, what else does this mean for index funds? Caroline Baron, regional head of ETF sales at Franklin Templeton, highlights the need for portfolios to have liquidity. Liquidity is even more important in times of uncertainty. She argues ETFs have several roles to play.
“If you look at the current market, one thing I see, and which I think has been underestimated, is the liquidity aspect,” she notes, speaking from her home. “ETFs have been playing a key role in that respect. With the kind of market turbulence we are currently witnessing, ETFs have delivered very well on that front. They have enabled investors to withdraw money quickly and reposition it somewhere else, so the liquidity angle is playing out fully in these challenging times.” The other benefit, she argues, is ETF transparency.
But the current crisis has revealed various market imperfections, according to Tobam’s Puhan – and liquidity risk is one of these.
“Today’s benchmarks in the equity space base their weights on market capitalisations, and in the fixed income credit space, on the value of outstanding debt. Over recent years, this led to significant exposures of the benchmarks to certain sectors and single stocks such as IT mega-caps and financials in equity markets and energy issuers in the credit market.”
Recent extreme illiquidity has been particularly pronounced in sectors that have been put under the most pressure from coronavirus volatility. Puhan observes that liquidity became tight even for the tech mega-caps that got a less-than-average beating – “even though they are thought of as being particularly liquid”.
“In extreme market sell-offs, this is not true. The mechanism is very simple: when passive investors sell, they will particularly push a large amount of these stocks into the market since they are just selling stocks all across the market mechanically and in times of high market concentration, there are few stocks with very high weights dominating the market,” she says.
“In the worst days of the recent market sell-off, we observed up to 160 stocks in the US large-cap index not starting to trade in the morning for a significant amount of time; for instance, the mega-cap Apple stopped trading before the market close.”
The situation has been even worse in fixed income markets. “The extremely deteriorated liquidity conditions in the fixed income market (despite billions of central bank money) had a significant impact on the major ETF instruments which are viewed as liquid instruments to manage credit exposure,” says Puhan.
Heavy concentrations and scarce liquidity in the credit market has seen investment grade and high yield ETF performance suffer during the mass sell-off, both in the US and Eurozone markets. “As a consequence, the largest fixed income ETFs traded at significant discounts to their NAV [net asset value] last week [mid-March].”
As an example, she offers the LQD iShares ETF, which replicates the iBoxx US IG liquid index, and which traded at a -5% discount to NAV on March 12 and 20. But, as Morningstar’s Bioy notes, strategies also exist that ought to protect investors in times of falling markets, such as minimum volatility funds.
At Franklin Templeton, ETF specialist Baron has been observing how ETFs have been “very resilient and doing what they’ve been set up to do”.
“From that point of view, it should be reassuring for any investor that, even in times of heightened volatility, ETFs have been able to deliver and help investors get in or out of markets whenever needed. Beyond that, if people understand that these conditions are not going to remain forever, there are some interesting opportunities from a pricing point of view,” she says.
For the moment, the clients Franklin Templeton deals with have not let panic take over, she adds.
Light at the end of the tunnel?
Investors are used to turbulent markets. Many have seen all manner of financial crises and managed to ride out the storm. As is often the case, a long-term view is crucial in times such as these – even if the light at the end of the tunnel seems more like a will-o’-the-wisp at present.
“Markets are so unpredictable at the moment,” says Bioy. “I don’t think anyone can say with confidence how they are going to be next week.”
One thing that is certain, however, is that many investors across the board felt a bear market was coming – given how high some valuations have been in recent times.
“It is actually not surprising that we are seeing stock markets, including those in the US, entering a bear market,” says Chung Man Wing, investment director at Hong Kong-based Value Partners.
“Global financial markets were already trading at all-time highs before the coronavirus epidemic, which put them at risk for a slowdown in earnings growth momentum.”
Even after the initial dip caused by the coronavirus – before its full impact took its toll across the globe – markets rallied to record highs. And since then it’s been nothing but volatility.
“The market volatility is affected by several elements and the Covid-19 outbreak represents only one of them,” says Chung. “What’s causing so much fear is much more complex – a combination of economic and financial shocks arising from the coronavirus epidemic, the overvaluation of stocks and bonds, excessive government and corporate debts around the world, and uncertainty created by social unrest and political conflict in many countries globally.
“From a historical perspective, we have always found making long-term investments during times of uncertainty productive, as quality companies’ share prices are hammered during a broad-based sell-off.”
While much of the world continues to reel from the coronavirus pandemic, China, where it reportedly all began, is beginning to show signs of recovery. According to a recent survey by Fidelity International, Chinese companies are better positioned to recover compared to their global counterparts.
Chung notes: “Much opportunity lies in Asia ex-Japan where the equity risk premium – the amount of return investors demand to be invested in stocks instead of risk-free bonds – is currently at 4.8%, the highest reading since the European debt crisis of 2011 and the 2008 financial crisis.”
The investment director adds that continued rate cuts as well as the lack of inflationary pressure are translating into increased risk premiums, implying higher future returns.
Although no investor can claim to have a crystal ball, perhaps that light at the end of the tunnel isn’t so far off after all – as long as you are looking in the right direction.
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