The likelihood of ongoing volatility during 2019 is prompting an increasing number of asset owners and consultants to ponder the impact on their growing exposures to passive investment.

The traditional pension fund core-satellite approach to asset allocation has seen a shift to better accommodate passive, or index-tracking investment, in recent years, with index replication strategies and smart beta ETFs finding their way into the core investment portfolio, along with multi-asset funds. 

Under this approach, asset owners manage market risk and interest rate risk in the core of their investment portfolios, while they hold less-correlated idiosyncratic risks in satellite parts, where they can pursue riskier strategies such as unconstrained investing.

It is recalibrating not only the traditional core-satellite model, but also return expectations from both actives and passives.

The Australian Future Fund CIO Raphael Arndt believes sizeable allocation active-listed equities are a good way to reliably harvest a risk premium over the long term. The Future Fund built its listed equities programme through external fund houses, combining active and passive managers for its predominantly long-only investment approach.

“Passive managers were complemented with active managers where we had conviction that active managers could deliver alpha, or outperformance net of fees, on a sustainable basis,” he said.

But as the tailwind of quantitative easing ceases, is the passive winning streak over? The flood of liquidity from QE caused the traditional inverse relationship between equities and bond performance to break down, with both performing well in the years after the crisis. For example, high-yield bonds have returns of 10.36% on average and investment grade corporate bonds have offered 10.57% returns over the past five years, while the S&P 500 equity index returned 15.7% over the same period, according to JP Morgan, Credit Suisse, and Barclays statistics.

Raphael Arndt

As this excessive level of stimulus reverses, there’s a risk that both asset classes fall in tandem too. Given that outlook, Arndt believes it’s important to think about risks, not just returns.

“This means asking what are the risks in your portfolio, and asking what would happen if growth stumbles, if interest rates rise more than expected or if debt suddenly becomes less available,” he said.

Mohamed El-Erian, chief strategist at Allianz and former CIO for fund house Pimco, believes asset owners need to adopt a multi-faceted attitude to equity risk.

“When you are an investor you look at three factors – the expected returns, expected variance or the volatility stream of those returns,” he told AsianInvestor while visiting Hong Kong in December. “And then you look at covariance, or how much you can mitigate in terms of risk. How much risk you actually take is a function of all three, not just one.” 


Ultimately, the best form of protection is investment diversification. And with the outlook of both public equities and bonds in question, that means looking towards illiquid asset classes. 

The Future Fund is an example. It believes equities remain expensive by historic standards even after sell-offs in November, with valuations susceptible to bouts of volatility. In addition, the sovereign wealth fund doesn’t have large holdings of bonds either, due to concerns over the cost of this asset class too. 

Instead, it hold assets such as venture capital, hedge funds and has a diversified global portfolio including significant exposure to currencies other than the Australian dollar. 

“We hold tens of billions of dollars in aggregate in these asset classes because they provide diversification away from equities,” Arndt said. 

Diversification helps offset risk, he said, but it’s important not to do so at the expense of all flexibility: “By this I mean holding cash and assets that can be liquidated at short notice. The reasons for doing so are two-fold: Firstly, to avoid being a forced seller of illiquid assets into a down market if there is a liquidity squeeze. Secondly, having the ability to invest into a down market when conditions permit and forward-looking returns look attractive.”

To that end, the Future Fund decided to sell around $5 billion of illiquid assets across a number of asset classes over the past six months. 


Of course, asset owners cannot avoid placing large sums of money into equities and bonds; they remain by far the largest asset classes. 

So the latest portfolio approach to these asset classes is to blend active and passive investments. Successfully implemented, that can create a dynamic investing approach that mixes different styles of investing. 

Dong Hun Jang

This evolution is more advanced in the US than in Europe and Asia, but is expected to spread. The idea is that the style is tactical, allowing investors and their fund house representatives to shift investing exposures rapidly. To do so, they need to utilise data and technology to assist in the portfolio management process, and allow them to engage in quantitative strategies. 

A survey by Create Research, which covered 153 pension funds and a global investor base with assets under managemnet of nearly $3.5 trillion, suggests investors understand that ‘passive’ is not an all-weather approach, and that many favour broader asset diversification that encompasses both active and passive investing styles, and changes according to market conditions. This appears to be the case with at least some Asian asset owners. 

“It becomes more doubtful to have the exposure to factor passive in consideration of the higher risk,” said Dong Hun Jang, chief investment officer of Korea's Public Officials Benefit Association (Poba). “I tend to prefer a simple and predictable core ETF strategy in a normal and range bound market. But if we were to enter a bear market, it would be desirable to increase the active element of the fund.”

That passive-active approach to investing within asset owners’ core portfolio is gaining traction: 2019 could prove an interesting test of this strategy’s ability to perform and adapt, particularly if a much-dreaded downturn does take hold. 

This story has been adapted from a feature in the AsianInvestor December 2018/January 2019 magazine.