James Klempster: The active approach to passives

The IPO of SpaceX in June was the largest ever. The minority of shares that were offered publicly raised $75bn, implying a total valuation of the company of $1.77trn.

Whatever the merits of the business, which has been greatly debated, it has brought into focus the role of passive vehicles in the functioning of markets and in client portfolios.

I want to stress upfront that this article is not about passive versus active management. We do not see this as a binary choice; as multi-asset investors, we use both.

What we want to propose is that there is a different approach to take, which will benefit investors given the extreme concentration of stock markets, the fragmentation of globalisation and the increasing focus on diversification.

As a result of being admitted to indices, including the Nasdaq from 7 July, trackers have a new tech addition in the form of SpaceX that increases the proportion of the US stock market associated with AI.

The US’s 10 largest listed AI-related stocks account for around two-fifths of the S&P 500’s value. Other stock markets have a significant concentration of stocks as well: in the UK, the largest 15 companies comprise 50% of the market while it is 19 stocks in the Pacific ex-Japan and 28 in Europe.

While passive investing has clear benefits, there is an ongoing debate about how it can amplify valuation distortions

The domination of US equity market indices by a small group of mega cap technology stocks reflects optimistic assumptions alongside historically high profitability. These dynamics have been reinforced by strong flows into passive strategies that have provided further momentum behind the share prices of the largest companies.

While passive investing has clear benefits, there is an ongoing debate about how it can amplify valuation distortions. If passive vehicles dominate market flows, they will continue to support stocks regardless of their business fundamentals and valuation, which is known as price insensitivity.

Any flow into a market capitalisation weighted index will go more to the mega and large caps than to smaller companies. This risks a virtuous cycle of net inflows favouring the largest companies, which grow and get yet more of the net flow.

Among the attractions of passive investing are their efficiency and relatively low cost, along with outperforming many – but not all – active managers.

Index design has evolved considerably over the past couple of decades with new rebalance techniques

Not all passives, however, are created equal. Most of the benchmark indices have a long-established history and over time have become an almost default approach to investing if you are not a passionate advocate for active investment.

There are many variations, however. For example, the choice of index, structure, replication methodology, domicile, market cap cut offs and issues such as size compared to market depth can all have a big impact on outcomes.

Index design has evolved considerably over the past couple of decades with new rebalance techniques, as well as the introduction of style indices, sectors and myriad other ways to try to wean investors off traditional market capitalisation weighted indices (and generally pay more for the privilege).

These enhancements are sensible but are variations on a theme.

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If there is a cooling in sentiment towards AI because it does not live up to the much-hyped expectations in the short or medium term; price inelasticity can work both ways. Just as a market cap weighted exposure through passive vehicles is indifferent to overpaying for a stock on the way in, it would equally be as indifferent to being underpaid on the way out.

What if there was a way to invest passively but also judiciously? What about an approach that benefits from the cheapness and simplicity of passive investing while also being price sensitive and active in its approach to investment management?

This can be achieved by building portfolios of passive vehicles in which every stage of the investment process is actively managed. The advantage of this approach is that the tactical asset allocation evolves according to the economic and market environment, and the portfolio construction reflects active views and ongoing monitoring while benefiting from the low cost of the underlying passive vehicles.

This reflects the fact that the Liontrust Multi-Asset team believes the biggest determinant of returns is not whether you choose active or passive but how you allocate across asset classes, regions and risk factors.

The outperformance of US equities in the decade up to 2025 obscured the benefits of diversification

Passive investing will remain a popular and important source of investing. There are risks, however, to slavishly following this way of investing without any active involvement.

This is shown by the fact we believe that diversification has come back into its own. The outperformance of US equities in the decade up to 2025 obscured the benefits of diversification.

But with the extreme concentration of stock markets highlighted earlier and the end of US exceptionalism and a less correlated world, diversification across asset classes, geographical regions, sectors and investment styles will become ever more important going forward.

James Klempster is deputy head of the Liontrust Multi-Asset team