Why some instos view passive funds with suspicion

While many investors across Asia are beginning to put more assets into passive funds, some remain reluctant to do so.
Why some instos view passive funds with suspicion
This story was adapted from a feature that originally appeared in AsianInvestor Spring 2020 edition in early March, which was published as the coronavirus was beginning to spread across the world. 
Passive investing is gaining more appeal among many of Asia's leading institutional investors. But not all of them.
Some of the region's leading asset owners require need further convincing before they will invest substantial sums in funds that only track market movements.
“In our conversations with clients, it seems natural for them to be more passive on global equities,” Janet Li, wealth leader for Asia Pacific at Mercer told AsianInvestor. “When it comes to fixed income, they tend to allocate more into countries, and there is a reservation to doing that on a passive basis. They worry is that issues may arise and force some [index constituents] into liquidation, and the portfolio performance is impacted.” 
This matches with the findings of AsianInvestor’s latest sentiment poll, conducted in late February. We asked how likely asset owners were to use more passive investments in fixed income allocations. Only 25% offered a medium to high likelihood they would do so, while 44% said it wasn’t likely and 31% had no plans to do so. The fund houses have their work cut out to change minds. 
Similarly, Willis Towers Watson’s senior investment consultant Richard Cooney noted that life insurers traditionally invest 85% or so of their assets in local fixed income. They are generally averse to passive bond investing, in part because they feel fixed income markets are likely to weaken selectively, offering “active opportunities for skilled managers to isolate and exploit”. 
“The case for adding some active management, particularly in growth assets, may intensify in our view – with either decelerating or outright reversal of flows to passive management in some cases,” he added. 
There is also a long-noted issue with some bond indices: the largest constituents are the biggest borrowers. That could prove a problem in a weakening global economy, particularly in lower grade corporate or high-yield debt. Those spaces in particular are likely to see a continued focus on active management. 
Certainly the need to perform well in weaker markets is on the minds of some CIOs. And that could
limit their interest in passive bonds, at least for now. 
“If we enter a bear market I think we may need to strengthen more high dividend stocks and defensive strategies, such as minimum volatility (investing factors),” said Jang Dong-hun, chief investment officer of Korea's Public Officials Benefit Association. “But my gut feeling is that maybe we will lower a bit from passive investment to active managers who can survive or really add value in bear market situation.” 
Yet the need to clamp down on costs across low-alpha parts of their portfolios is also likely to prove a driver. It’s entirely possible that more asset owners end up deciding to add passive investing in the most liquid areas of fixed income (think US Treasuries, or European Union government bonds). 
Ultimately, the level of engagement that Asia Pacific’s asset owners apply to passive investments is likely to reflect market realities. US large cap equities appear a place for passive; high-yield fixed income far less so. 
But flows of funds to passive investments look likely to keep rising in total. And as cost pressures mount and investment returns become harder to find, it could cause more asset owners to reweigh how they measure performance. 
It’s possible that more ultimately decided to take an approach like sovereign wealth fund New Zealand Super, and allocate a broader amount of their investments to passive investments, particularly using environmental, social and governance considerations. They’re also likely to reserve a sizeable minority of their investment portfolios to active investments where there is demonstrable alpha to be found. 
Private equity, real estate, private debt and infrastructure are some areas, but active investing also looks likely to hold sway across large parts of corporate bond investing, emerging markets, and unconstrained portfolios. 
Passive investing looks likely to keep building as a core concern in asset owners’ investment portfolios. The inability of many fund managers to find alpha in liquid mainstream markets, especially equities, and the desire of investors to invest in ESG as easily as possible look set to help drive it. 
It’s a case of evolution, not revolution.
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