Dynamic Equity Exposure:
Adapting to Changing Market Environments

December 2018 | Retail Version


  • Last July, we warned investors that the FAANG stocks could be hit significantly harder than average in the event of market turmoil given their allocations to passive strategies. This materialized between June and December.
  • Despite some market turmoil in 2018, fund assets in passive strategies increased from 46.15% to 48.15%, further growing the potential passive investing bubble.
  • Historically, investing in unconstrained, high-active share funds has resulted in outperformance relative to benchmarks in a variety of different market environments.

We believe that 4Q 2018 provided insight as to what might happen to investors exposed to a potential passive investing bubble in the event of more prolonged market turmoil. The S&P 500 TR Index declined by -13.52%, while the FAANG stocks dropped by an average of -23.41%. In fact, some of the top contributing stocks as of June 30th ended the year as some of the bottom contributing stocks.

In our July 2018 piece, “The Passive Investing Bubble,” we provided evidence to suggest the potential formation of a passive investing bubble. The thesis was as investments into capitalization-weighted indexes increase, the largest stocks that performed the best tended to get a disproportionately large allocation, creating a self-reinforcing cycle of these stocks performing well. In the event of market turmoil, investors with heavy exposure to certain stocks may experience significant losses. We cautioned that investors should be concerned about exposure to FAANG stocks given their allocations in passive strategies and their potential downside risk.

In the face of market volatility, it is important to be dynamic and adaptable to ever-changing market conditions. Being constrained to certain sectors and Morningstar categories limits the opportunity for outperformance. We believe that the recent return of market volatility leaves a lot of space for active managers to add value, particularly if market conditions deteriorate and assets flee passive strategies.

Over the past decade, assets have shifted from active to passive funds, with 2019 expected to be the tipping point where most assets are in passive strategies.

A Potential Passive Investing Bubble: Percentage of Assets in Active and Passive Funds

Chart represents the percentage of assets in active and passive mutual funds and ETFs since 2008. 2018 percentage is as of 11/30/2018. Source: Morningstar Inc.
*2019 projections are based on annual average growth rate from 2008 to 2018.


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