Passive equity strategies have grown to dominate the investment landscape, but rising concentration risks, benchmark performance tests, and hidden passive costs are prompting asset owners to consider more nuanced approaches. 

Brighter Super chief investment officer Mark Rider said the $36 billion fund’s low-fee focus in its MySuper fund led to a purely passive equity portfolio, but in the last 12 months it had added more active approaches given changing market conditions.  

“The problem is that what tends to happen with concentrated markets is active management can be an issue,” Rider said on a panel at the Investment Magazine Fiduciary Investors Symposium. “So we’ve probably leaned more into the systematic and quantitative side because that risk control is much better.” 

The IT sector now accounts for 35 per cent of the S&P 500 – a similar level to the dot-com bubble – and the Magnificent 7 account for 33 per cent of the index, according to the IMF’s October financial stability report. 

TelstraSuper head of equities, Dominique d’Avrincourt, said all of its active managers had an underweight to the mega-cap tech stocks, but she did not expect market concentration to end. The fund hedged its active managers’ underweight position using an S&P 500 futures position. 

“I don’t think it’s going to be like the tech bubble because these companies are profitable, they’re growing exponentially, they’re building, they’re growing their client base,” she said. 

She cited research by Professor Hendrik Bessembinder, which showed that very few stocks have driven returns over decades – and passive strategies deliver the average of the market. 

“There is a role for it, but it’s not going to give you the excess return that you are looking for in trying to maximise returns for members.” 

The shift to quant  

TelstraSuper has an “all-inclusive” approach with passive, active and quantitative strategies with the objective crucial when constructing the equity portfolio.  

“In our portfolio, the quant process is funded from passive largely because the objective is to sweat the beta and make it work harder for what we’re paying for it, and the IR [information ratio], hopefully is closer to one. It has been closer to three in the last three years, because it’s been such a successful way of investing. I don’t think it’s sustainable, so I assume one.” 

The fund does not employ a quant strategy in Australian equities because the market is strongly driven by momentum, which leads to high turnover. Its global equity quant strategies are diversified across all factors, with a focus on idiosyncratic ideas. 

“Every single manager will have different ideas, so you have to believe in those ideas, and every single manager has a different way to implement it and to construct the portfolio. That’s the critical bit, because that’s what differentiates ‘quant’ from quant.” 

JANA head of research execution, Matthew Gadsden, said most of the asset consultant’s clients employ a core-satellite approach (with core at 0-1.5 per cent tracking error). Core allocations had increased over the last decade due to regulation, cost, and a desire to deliver more consistent results.  

“Acknowledging that fees are a constraint, we have seen enhanced index as a systematic strategy increase in that component.” 

The costs of passive  

Dimensional Australia chief executive, Australia and senior investment director, Bhanu Singh, said market orthodoxy is to buy a low-cost index to get market exposure but low fees don’t always equal low cost.  

He cited Tesla’s delayed inclusion in the S&P 500 as an example of what he called the “waiting room effect.” Although Tesla ranked as the 60th largest U.S. stock in January of the year it met S&P 500 profitability criteria, it wasn’t added until November. By that time, it had become the sixth largest. 

“There’s not a lot of transparency around when and why stocks are added,” Singh said. “A lot of names spend months or longer outside the index despite qualifying for inclusion.” 

Singh also pointed to overlooked sources of return and cost in passive portfolios, such as securities lending. In one case, a large U.S. institution discovered it was paying 40 per cent of lending revenue to its agent, even though the standard fee was just 10 per cent. 

“That’s essentially a fee that’s not disclosed – the headline fee.” 

Index rebalancing poses another cost. Stocks being added can run up 5 per cent or more before the rebalance date, only to fall after inclusion, leaving index investors “buying high and selling low.” 

“If you’re an index investor, you are a price taker,” Singh said. “You just basically wait for that peak.” 

He suggested a more flexible approach to manage these issues, including accepting a small increase in tracking error (0.5 to 1 per cent) to deliver a better result.