What can be seen from the chart below is that over the last few years passive exchange traded fund (ETF) investing has become very popular. This popularity has risen because investing in ETF’s is generally regarded as low-cost when compared to investing via active managers who charge higher fees to deliver active management.
This may work very well when the market is moving in a straight-line upwards, but it is not so effective when the bull market gets punctuated with volatility and corrective behaviour as we have seen in the last couple of weeks.
Many ETF investors believe they are protected because the funds they are investing in are highly diversified. Unfortunately, this has not been the case recently. Markets have become very concentrated in recent times. For example, over 50% of the rally in the US’s Dow Jones Industrial Index in 2017 came down to just five stocks and in New Zealand, over 50% of the share market performance in 2017 was attributable to just three stocks.
The recent market activity, in my opinion, emphasises the importance of smart active management. Smart active management is not the blind strategies that are deployed by algorithms and robo-advice tools which deliver automated, indiscriminate buying of passive ETFs. It requires the skill and discipline of knowing when to sell or not to sell, when to raise cash, when to deploy options strategies, and when to reduce the overall impact of market movements on a portfolio, not to mention a fully-fledged shift in asset mix when conditions call for such a change.
For example, a number of Milford funds recently took advantage of cheap volatility on share markets to buy put options (analogous to insurance) to protect against market falls. This strategy paid off handsomely in the recent bout of extreme volatility as ETF investors did the exact opposite (sold during and after a price drop). This can be seen by the orange line in the following chart:
Source: Bloomberg
In my view, the key to successful long-term investing is to manage risks within specific investor risk/return profiles, focus on capital preservation and be responsibly proactive and tactical. Especially as we potentially enter a new phase of this bull market with more two-sided trading and the prospect of heightened volatility.