The Fed and the ECB Are Making Passive Investing Trickier


Over the last 10 years, investors have been rewarded for keeping it simple. Passively invested assets have grown five-fold and been lucrative. Simply tracking the S&P 500 over this period meant almost tripling one’s money. Meanwhile, actively invested assets have suffered and shrunk. In the U.S., fewer than 20% of active managers beat their index-styled competitors in the last decade.

But the popularity of passive investing may soon be on the wane. The main reason is a change of central bank behavior that encourages investors to take a more active stance. The European Central Bank is under strategic review, and the Federal Reserve is changing its approach in making policy decisions based on actual data — which comes with a time lag — instead of on forecasts. As central bankers turn reactive, market participants have no choice but to take a more proactive seat. 

In the past decade, central bankers ran the show. Monetary policy dictated asset price returns and investors got used to making decisions on the back of central bankers’ communication. With central banks willing to do whatever it takes to prop up the markets, and enough conviction in the markets doing well, why attempt to beat them via strenuous and costly analysis? Tracking the market is what passive investing was designed to do, making it a logical and profitable route to generating returns.

Since the start of this year, however, investors have been challenging the stubbornly dovish decisions by the Fed, the ECB and other central banks, and pricing in different interest rate scenarios. This makes passive investing a less straightforward proposition.

Markets are pointing to the elephant in the room: Why is the Fed still buying $120 billion of bonds per month— a program initiated while navigating blind in the depth of the pandemic — when we’ve seen major progress since then? U.S. unemployment has fallen from 15% to 6% - only 2% points above pre-pandemic levels. Global manufacturing is around a decade high and global household savings are double if not triple pre-Covid levels.

Investors fled from bonds at the beginning of the year as they anticipated inflation and subsequently higher rates. This led the U.S. 10-year Treasury yield to shoot up from 1% to 1.5% in only six weeks, despite Fed Chair Jerome Powell insisting being “a long way” from the Fed’s inflation target and remaining unwilling to raise interest rates.  

Of course, central bankers are nervous about turning hawkish too quickly. They remember the 2013 taper tantrum, in which investors panicked on the back of a mere possibility of the Fed reducing its support to markets — so much so that instead of reducing support, the Fed ended up increasing it. Plus, there are still unknowns about how the services economy will recover. Unlike in previous recessions, Covid-19 may have longer-lasting impact on businesses like restaurants, cinemas and so on.

Yet markets remain unsatisfied by this rationale. Although Powell cited no rate hikes until at least 2024, a faster-than-expected economic recovery has traders expecting the Fed to lift rates from 2022 onwards. This is visible in pricing action in Eurodollar and Fed Funds futures market, which both track short term interest rate expectations. Correspondingly, the banks sector — the ultimate beneficiary of rising rates — has had an enormous run year to date, outperforming the S&P index by 20 percentage points.

Investors appear to be acting against what central banks are saying. This diminishes central bankers’ grip on the markets, which in turn diminishes the proposition offered by passive investing strategies of just buying the index. “Fed put” — the mantra that central banks will always rescue the market — only works if the Fed is in control.

The reaction to Treasury Secretary Janet Yellen’s comments this week provided an interesting plot twist. Yellen stated that interest rates may have to rise somewhat to make sure the economy doesn’t overheat. This triggered a sell-off in U.S. tech stocks, which are sensitive to rates, following the classic pattern of markets reacting to signals of monetary policy. But this time the signal didn’t come from the Fed. Yellen essentially reinforced investors’ belief that rates are going up sooner than the Fed is communicating.

If rates are set to rise, then equity indices, which benefited from investors having fewer options for yield, become less attractive. 

This means a more hands-on approach to investing — i.e., making decisions on individual securities versus on an index — will increasingly be required to generate returns. Yet this requires a deep understanding of a company’s earnings drivers.

Active investing connects the share price of a company to its underlying business model. Over the longer term, a company’s share price converges to the compound annual growth rate of its earnings growth. Active investors enjoy moments when earnings growth outpaces share price growth because that usually leads to an earnings multiple catch-up and thus strong returns. (In the low interest rate environment of the last decade, we saw more of the opposite — multiple re-ratings.) Investors get to weigh the trade-off between the negative effect of higher interest rates – ebbing away at the value of future cash flows — against the positive effect of higher earnings growth.

Ultimately, the last 10 years rewarded a piggybacking off of central bank policy. This passive approach was simple yet highly effective, while an active approach often fell victim to missing the forest (overarching monetary policy) for the trees (idiosyncratic security stories). The shift in roles between central banks and market participants is starting to shake things up.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Anneka Treon is a managing director and head of the Competence Center at Van Lanschot Kempen.

©2021 Bloomberg L.P.

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