Rising Rates and Volatility: Trouble for Passive Value Investors?

By Peter Hardy, CFA - August 22, 2018

We believe passive and active strategies are complementary tools that may lead to achieving successful investment outcomes. There are benefits to each approach, and over time, each enjoys its day in the sun. After an extended period of strong performance by passive strategies, we believe rising interest rates and more volatile market conditions could spell trouble for passive investors, particularly passive value investors.

Active and Passive Performance Is Cyclical

Active and passive strategies rotate in and out of favor as market conditions change. Historically, passive approaches have outperformed when interest rates are stable or falling, and the stock market is strong and trending upward. These conditions were in place for the long stretch of passive outperformance following the 2008 market collapse. Active strategies tend to perform better against a backdrop of rising rates and more volatile market conditions.

Cash Flows Follow Performance

Supported by historically low interest rates and unusually low volatility, the recent period of passive outperformance triggered massive outflows from active strategies. From 2014 to 2017, $555 billion poured out of active mutual funds while passive funds raked in $553 billion1. These cash flows, along with $1.5 trillion2 in active outflows from institutional investors, helped sustain the passive cycle. They also drove up valuations in rate-sensitive corners of the stock market.

Rising Rates Might Be a Harbinger of Change

The Federal Reserve (Fed) is well down the path to normalizing interest rates. After holding rates at low levels in the wake of the Great Recession, the Fed began raising them in late 2015. Central bankers have raised the target rate from 0.25 percent to 1.75 percent and have signaled continued hikes through 2019. Historically, such shifts have triggered increased market volatility and changes in market leadership.

Passive Value Investors May be Overexposed to Expensive, Rate-Sensitive Sectors

The low interest rates of the post-recession years created an extreme chase for yield. Many investors flocked to high-dividend stocks and higher-yielding areas such as utilities and real estate. The resulting cash flows pushed up stock prices, driving high valuations and larger weights in rate-sensitive sectors of value indexes. We believe these areas are now too expensive, and active value managers, on average, are underweight3. For passive value investors, higher exposures to utilities and real estate may be locked in.

Receding Tailwinds for Passive

With interest rates rising and more normal levels of volatility returning to the market, we believe the tailwinds for passive strategies may recede. We expect these conditions to herald a change in market dynamics and leadership that could place passive strategies at a disadvantage. We believe this environment lends itself to active management and the ability to add value through stock selection, portfolio construction and risk management.

Peter Hardy, CFA
Peter Hardy, CFA

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Rising Rates and Volatility: A More Positive Environment for Active Value Investing

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      1Morningstar, Inc.

      2eVestment Alliance, LLC

      3Morningstar, Inc. Data as of 12/31/17.

      Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.

      Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

      The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.