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For the last few decades, depending on passive investing strategies for reliable returns has been the status quo for financial advisors. Passive, index-based investing has traditionally provided broad exposures. This strong diversification, paired with a relatively stable global environment defined by free trade and limited conflict, has left advisors without needing to track geopolitical developments for market impacts too closely.
However, this investment environment has now been turned on its head. Significant geopolitical escalations have recently created a landscape where trade disputes between major economies, inflation, and conflict are major concerns.
Markets are consequently becoming more sensitive to political developments. The S&P 500, for example, recorded its longest weekly losing streak in four years as a result of the ongoing conflict in Iran. The benchmark index fell 8.74% from its peak in January.
However, the intervening weeks have seen the index move back toward all-time highs off the back of tech earnings and optimism around the possibility of a peace deal, with the index rising roughly 10% since the April lows. Moves like this highlight just how quickly sentiment can shift. Now, add the growing concentration around major tech companies within these indices, and the risks associated with a passive approach suddenly become difficult to ignore.
The rules have changed
When it comes to investing, company fundamentals and key market trends have typically taken precedence over wider macroeconomic and geopolitical activity. Inflation and interest rates were predictable, and trade policies could be depended on, enabling investors to build portfolios that reliably tracked market benchmarks.
But this is no longer the case. We now live in a world where geopolitical volatility is a market driver that must be taken seriously. New tariffs and trade restrictions show that we’re moving away from the globalized trade network that markets have relied upon for stability, upping the risk of supply chain disruptions that can have significant effects on markets.
Intense periods of market stress can now see macro risks playing a bigger role than company fundamentals, and businesses now have to learn to adapt to supply chains that shift beneath their feet for reasons beyond their control.
As a result, pressure on advisors’ margins is ramped up along with broader risk levels. Relying solely on benchmarks without the agility to quickly shift allocations means exposing clients to more risk than they bargained for.
Market concentration presents further risks
Concentration within today’s indices adds another layer of complexity. Portfolios are becoming dangerously overexposed to a limited selection of large tech companies. That means investors using passive index strategies may not be as diversified as they think. What appears to be diversification can, in practice, mask significant concentration risk.
The “Magnificent Seven” represented roughly 34% of the S&P 500 in mid-May. This is a huge increase from just 12.5% in 2016, and means that movements in a handful of stocks can have a disproportionate impact on overall market performance.
The recent surge in AI-related stocks, followed by periods of volatility, has shown how index performance is increasingly driven by a narrow set of growth themes.
These companies are also exposed to similar risks, particularly those linked to the success of their AI investments and the impacts of geopolitical uncertainty. If these themes were to reverse, the impact would be felt across a large swath of the market.
As geopolitical uncertainty rises and market breadth narrows, the traditional benefits of passive investing become less reliable. Passive strategies can now leave investors more exposed to concentrated market risk, rather than diversifying them as intended.
Under such an investing climate, active management emerges as the winning strategy for increasing flexibility, enabling advisors to adapt more quickly to any geopolitical shocks and better protect their clients.
Success in active management
Generating diversification for clients today is about having the agility to adapt to a rapidly shifting market, not just holding onto a broad array of assets. In practice, this comes down to monitoring portfolios regularly, rebalancing positions more frequently, and stress-testing allocations against different macro scenarios. However, this is a lot of work and, as advisory shops scale and manage growing numbers of clients, active management can become highly operationally intense.
Fortunately, technology can make this more manageable. Automation and AI tools can now build portfolios within defined parameters, monitor for risk, and even execute trades autonomously. This can help advisors scale faster while still managing a heavier load of clients. It also ensures that potentially dangerous concentrations can be avoided and enables portfolio managers to respond fast to market events.
Challenging times call for more proactive measures. Active strategies have outperformed passive ones in 21 of the past 28 market corrections, delivering an average excess return of just over 1%. While this may appear modest, it can have a meaningful impact and significant outcomes for clients, in addition to helping them beat market benchmarks.
The market has changed, and advisors’ strategies must evolve alongside it. With geopolitical factors playing a more prominent role in shaping returns, active portfolio management will become an increasingly necessary approach for advisors seeking to navigate uncertainty and deliver consistent results despite a turbulent market.
Wes Caywood is head of distribution at Pave Finance.
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