Do Passives Increase Risk

pip895

I have been looking into moving more funds from active to passive, primarily to save fees. My concern is that it looks as though I will be increasing the risk of significant falls in a downturn, by doing so. When I look at the risk profile of my proposed new portfolio (same equity percentage as the old one) the risk score (via Trustnet) increases from 58 to 76. Which to put it in context is pretty similar to going from VLS60 to VLS80.

Part of the issue might be that in selecting my active funds I have deliberately picked funds that have low volatility and/or funds with a reputation/mandate of downside protection – this isn’t an option available with most passives.

I have one portfolio that I run with a higher equity and risk profile which has a risk score of 75. That portfolio made nearly 20% last year as opposed to under 15% in my more cautious portfolio. The new passive version I am looking at made only 12%.

I realise that the risk scores I am using are an imperfect representation of true risk, however it leaves me wondering if it is worth changing things for what would be only ~0.7% reduction in costs.

dunstonh

Do Passives Increase Risk

No. Not because of their investment style.

However, every fund in a sector carries a different risk. The differences can be significant. A few years back a company mapped the funds in a sector to a 1-10 risk scale and found one sector had funds ranging from risk 3 to risk 8.

So, its more about investment objective and fund rules than whether it is specifically a passive.

For example, the FTSE250 trackers are in the same sector as the FTSE all share and FTSE100 trackers. However, all three have very different risk levels. All three are in the same sector as UK equity managed funds. Some will have defensive stances, others more aggressive.

Part of the issue might be that in selecting my active funds I have deliberately picked funds that have low volatility and/or funds with a reputation/mandate of downside protection – this isn’t an option available with most passives.

The score is based on the underlying assets at that particular moment in time rather than the investment objective.

bostonerimus

I imagine that risk number you are quoting is closely related to the standard deviation in the price or returns of the fund. It has nothing to do with being passive per se, it's to do with the composition of the fund. I think you might have picked up on the idea that active funds can be managed to reduce risk in down turns by adjusting the asset allocation and something like VLS60 can't do that as it has a fixed allocation and simply rebalances, VLS60 isn't entirely passive. I've found rebalancing in down turns and bull markets to be a good strategy.

Part of the idea behind buying indexes is that it eliminates the risk that you won't own a winner or be the victim of a bad manager pick like Woodford's were investors last year. Of course you also won't benefit from returns like Fundsmith last year, but that fund only owns 28 stocks so it sounds pretty risky to me even if they are picked with strict criteria for profitability and volatility. So look at the actual sectors and stocks owned in your two portfolios and you will probably find an explanation for the risk numbers you are seeing.

Linton

Passives dont of themselves increase risk. However passives dont make a poor or excessively risky area any less undesirable - eg FTSE100. Some active funds may actively seek to reduce risk.

TheLastMongoose

When you track an index you buy every stock with no consideration of value for money and you buy more of the larger companies than the small ones. I suspect the increase in passive investing (amongst other things) is over-inflating stock prices to a small extent. There certainly seem to be some silly P/E ratios around at the moment. As a result I expect that when there eventually is a crash the equities in my passive portfolio will fall faster and further than a portfolio of decent active funds.

I will be invested for nearly 30 years yet so personally I don't consider this a risk as I won't be selling at this time. I hope that when my passive portfolio recovers it will just end up back near or above its previous high at some point. When its falling through the floor is just a good buying opportunity. The further it falls the further my £££'s will go.

If I thought I might need to sell during or near a downturn I probably would not be heavily invested in passive equity index trackers.

bostonerimus

EJS_Superted wrote: »

When you track an index you buy every stock with no consideration of value for money and you buy more of the larger companies than the small ones. I suspect the increase in passive investing (amongst other things) is over-inflating stock prices to a small extent. There certainly seem to be some silly P/E ratios around at the moment. As a result I expect that when there eventually is a crash the equities in my passive portfolio will fall faster and further than a portfolio of decent active funds.

If you don't believe in efficient markets then you should not be investing in passive indexes.

pip895

Over the years I have sacrificed growth in order to give myself downside protection - partly by using bond funds but also absolute return and flexible investments. We don't have immediate need of the funds although we are retired. Its just I really don't fancy my OH's reaction to learning that we have lost 40-50% of our retirement fund - he is a rather nervous investor lol.

I know I would make more money in a good year and indeed on average by accepting a higher risk and increased equity percentage. It seems counter intuitive to accept a higher risk without getting noticeably better performance though. I just don't think the level of the cost savings are enough of an incentive for me.

pip895

bostonerimus wrote: »

If you don't believe in efficient markets then you should not be investing in passive indexes.

Does any one believe in completely efficient markets??
If markets were efficient then you wouldn't get bubbles and crashes at all would you?

bostonerimus

pip895 wrote: »

Does any one believe in completely efficient markets??
If markets were efficient then you wouldn't get bubbles and crashes at all would you?

Well, if there is a bubble then a crash is the market reacting to it and being "efficient".

TheLastMongoose

bostonerimus wrote: »

If you don't believe in efficient markets then you should not be investing in passive indexes.

I believe markets are efficient if you wait long enough but they aren't always efficient in the short term. It's easy for me investing for 30 years in a LISA to just go with 100% of my money in equity trackers but if I was only planning to stay invested for 10 years I would want a different option. Especially at this point in the economic cycle. Yes I might stay semi-passive with something like VLS40 or I might go for a defensive managed fund. Maybe a bit of both. As the OP says I certainly wouldn't choose either because of a saving of a few 10ths of a percent although it's always a consideration.

OldMusicGuy

It's not just passive vs active, different passives have different risk profiles. I found this link (that someone posted on another thread) interesting: https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations