Passive investments such as exchange-traded funds allow investors to “buy-and-hold” positions in vehicles that offer lower fees and track the performance of specific markets or indices.
Passive investment vehicles have grown in popularity over the past several decades, but some market observers have expressed concerns that they now have an outsized impact on volatility and need to be reined in. This surge has become such a hot topic in recent years that experts predict that passive equity investments will surpass actively traded equity assets in 2019. This seismic change in market structure has been brewing for many years and has both positive and negative aspects worth examining.
“Our investors are incredibly savvy and in tune with the markets,” says Andrew Molloy, relationship manager for Hilton Capital. “Passive investments are common in a client’s portfolio, so the question as to whether they pose undue risk comes up quite frequently.”
Alex Oxenham, Hilton co-chief investment officer, acknowledges the impact of exchange-traded funds (ETFs) but isn’t as pessimistic as some of his colleagues in the industry. “There’s no question ETFs are incredibly popular,” he says. “If you’re a long-term, passive investor ETFs can be very effective. Even self-described active investors balance their portfolios with ETFs. Overall, they have been terrific for the investor class.”
“Our job,” he continues, “is to understand how they impact the marketplace and adjust accordingly.”
“Market structure doesn’t impact the fundamental investment decision process. But it will influence position sizing and factor exposures, which will ultimately impact the composition of the portfolio.”
Hilton Portfolio Manager Tim Reilly expresses a similar sentiment. “Market structure doesn’t impact the fundamental investment decision process,” he says. “But it will influence position sizing and factor exposures, which will ultimately impact the composition of the portfolio.”
According to Reilly, the flagship approach for Hilton Capital is the Tactical Income Strategy, which isn’t significantly influenced by market structure.
“The impact on Tactical Income has been, and will continue to be very small,” he adds. “Given the longer-term nature of our investments the impact of passive investments and market structure is fairly muted. The key driver of performance is our macro view and asset allocation, neither of which are significantly impacted by market structure.”
Understanding Passive Investments
Passive investment vehicles have enabled investors to participate in the market without incurring fees associated with active trading. Passive investors are typically considered “buy-and-hold” participants who are more interested in long-term growth rather than short-term gains. The most well-known examples are index funds, which are mutual funds designed to mirror certain markets or sectors, and exchange-traded funds (ETFs) that allow investors to track a major index.
The obvious, inherent risk in this strategy is that the investment reflects the performance of the entire baseline index or market. Thus, when an index declines so too does the investment. Like most comprehensive investment strategies, a diverse portfolio can help mitigate such risks. Nevertheless, passive vehicles such as ETFs have gained enormous traction and popularity, and saved “investors many billions of dollars both directly and indirectly, through the price pressures they have put on traditional asset managers,” according to the Financial Times.
“ETFs are another in a long line of innovations that present both challenges and opportunities.”
While index funds have been around since the 1970s, ETFs were established in the 1990s and have gained enormous popularity among passive investors. The rise of passive investment vehicles has created concern among some in the investment community because of their outsized ability to move markets and increase volatility. The mechanics behind these moves are fairly straightforward. If a large institutional player moves some or all of its stake in an ETF, as an example, it can potentially rupture the stability of an entire sector or index.
Navigating Structural Changes
“Look at it from 10,000 feet,” says Oxenham. “Markets are continually experiencing structural changes. Leverage can change market fundamentals. The advent of high frequency trading and an algorithm-driven world are new realities that few would have imagined 15, 20 years ago. ETFs are another in a long line of innovations that present both challenges and opportunities.”
Hilton Capital President Craig O’Neill agrees, adding, “Alex is right. The key is to acknowledge the change, understand it and adjust. Look at the undeniable impact the quants [quantitative analysts] have had on trading, which makes our focus on fundamentals and value even more critical.
“There are macro factors to consider as well,” continues O’Neill. “The global economy is increasingly interconnected and interdependent. These are changes to market forces as opposed to market structure, but they all work in concert.”
“It’s good to have these conversations and to continue to innovate but stay disciplined,” adds Reilly. “Our Tactical Income strategy has levers such as fixed income in place to mitigate risk whereas Tom [Maher] just launched a pure equity strategy focused on small and mid cap opportunities. In both cases, you have to incorporate factor or industry exposures into your investment thesis as these considerations could impact price performance more than traditional data points.”
“Hilton has a 19-year track record successfully navigating these kind of structural changes,” concludes Reilly. “Yes, passive investing has clearly altered market structure and impacted daily moves across all markets. It has also influenced volatility, liquidity, correlation, and at times, pricing inefficiencies. As a result, market structure could impact individual position sizes, and ultimately, overall asset allocation of the portfolio. Or as Craig says, understand it and adjust.”
Morey Creative and Hilton Capital Management staff (“HCM”) collaborated in the preparation of this article. Morey Creative is a marketing firm engaged by HCM. HCM has reviewed and approved this article for distribution. The information set forth in this article should not be construed as personalized investment advice. There is no guarantee that the views and opinions expressed in this article will come to pass. Investing in the markets involves gains and losses and may not be suitable for all investors. The information set forth in this article should not be considered a solicitation to buy or sell any security.