For a safer, smarter investment journey get into the driving seat

By Didier Rabattu, Head of Global Equities, Lombard Odier Investment Managers

Following a prolonged bull market, the rising number of investors who have chosen to track the market have seen little reason to question the so-called ‘passive’ approach to investing. However, the limitations of passive investing could become painfully evident when the market shifts direction. How can investors navigate markets more safely?

Riding the bull market, but for how long?

There has been a huge increase in passive investing – investment approaches that track broad market indices rather than taking ‘active’ investment decisions. In the last decade, over USD1 trillion¹ is estimated to have flowed out of active funds, with passive solutions – offering investors broad market access in a cost-efficient way – attracting strong inflows.
 

They have been handsomely rewarded as indices worldwide experienced a bull run that is remarkable both in its magnitude and longevity. Stellar performance has made it easy to overlook any shortcomings or concerns relating to tracking an index.

However, bull markets can quickly turn into bear markets and index-tracking investors may be particularly susceptible to any reversal of fortunes.²   

The drawbacks of following the crowd
 

While following the crowd can feel like a comfortable option, allowing investors to ride the wave of rising markets, it also means investors get dragged down with everyone else when the tide turns. Taking a passive approach by definition means choosing not to make proactive investment decisions, regardless of what the market throws at you and irrespective of the opportunities that arise within a given investment universe as the sands shift.

The benefits of being selective

While it can be tempting to follow the crowd, if investors instead choose an active approach to investing – one that focuses squarely on the intrinsic qualities of each individual investment – they can steer their own path while seeking to tap into a range of opportunities.

Carefully-managed active investment approaches allow investment managers to make case-by-case investment decisions based on each company’s individual merits. By allowing the investor to place the correct value on strong companies – regardless of their market capitalisation – active approaches can provide a safer portfolio in case of a downturn; it is logical that stronger companies may be better-placed to weather any storms.
 

But being active is not just about aiming to cushion investors against the downside, it also means trying to improve the upside by finding companies that the investment manager believes can provide better returns than their peers in good times as well as bad. At Lombard Odier Investment Managers we believe that investing with high conviction is critical in a world where many traditional asset classes offer low return potential and are highly correlated. Our high conviction proprietary process is centred around the selection of companies with sustainable business models that we believe can deliver attractive economic returns which are mispriced by the market.

We strongly believe that companies with sustainable business models and which are resilient to economic changes offer the best opportunities to investors. We view high-quality companies as those which generate excess economic returns over economic cycles; such companies will typically be very efficient in their use of capital, be cash-generative and not be dependent upon financial markets for financing themselves.  And in order to sustainably generate such returns, these companies will have built up strategic barriers or lines of defence against threats stemming from competitors, suppliers, or regulation.
 

We believe that markets often overlook and undervalue these companies and that a disciplined approach to identifying quality companies, complemented by fundamental analysis, can help identify best-in-class stocks as well as opportunistic investments.  Furthermore, as an active investor we are also able to take into account extra-financial considerations such as a company’s practices and achievements in environmental, social and governance issues, while also seeking to avoid companies that are highly controversial.

The opportunities for active investors are particularly compelling in those markets that are characterised by diversity, in our view. Take emerging markets: a heterogeneous group of countries each with very different dynamics that are ignored by market-capitalisation indices and thus missed by passive investors. Active investing allows an investment manager to favour investments in those countries, sectors and companies that he/she believes is best-positioned for growth in light of geopolitical trends and other important market dynamics. For example, higher uncertainty around global trade flows has underscored the need for emerging market economies to focus on increasing home-grown demand for their goods and services while reducing their reliance on exports. There is huge diversity in how well-positioned different emerging markets (and the sectors and companies within these) are for this shift and only active investors can seek to identify those that are best-positioned.

Time to strengthen the foundations

Passive investors should resist being lulled into a false sense of security – at some point there may be an abrupt market correction or market rotation as the bull market comes to an end, and investors need to ensure they position themselves for this. We believe that quality-based, high-conviction investing is the rational, prudent way to invest in equity markets.

Read more from the FT on passive investing here

¹ Investment Company Institute Fact book 2017; outflows from actively managed domestic (US) equity funds, January 2007 – December 2016.
² The term “bull market” signifies a financial market that is rising in value or expected to rise in value; conversely, a bear market is one that is falling.