Benchmark-clinging passive investors risk meagre returns: Perpetual

Perpetual head of investment strategy Matt Sherwood has warned that passive investors banking on a repeat of the past 15 years of very strong global equity returns may be sleepwalking into a decade of disappointment.

Sherwood said the past decade of US exceptionalism, marked by the extraordinary run of the Magnificent Seven, has created very strong global equity returns for passive and momentum investors, whereas the rewards from diversification have been meagre.

But looking ahead, elevated stock valuations in the US suggest more muted returns.

The Perpetual Capital Markets Estimator, which projects 10-year expected returns across various assets, indicates that due to the "extreme valuation" of US equities and their dominant 70% share of the MSCI World Index, investors in conventional global market cap indices shouldn't expect higher returns for taking on greater risk.

This outlook is similar to that of MSCI head of research Ashley Lester, who recently told Financial Standard that while the US has been "the only game in town" for the largest institutional investors and individual wealth managers looking to move substantial capital, even long-term investors are starting to reassess their heavy allocation to a single market.

Sherwood identified four drivers behind elevated valuations - declining discount rates over three decades, four rounds of US Federal Reserve quantitative earnings during and after the Global Financial Crisis and the COVID-19 pandemic, lower tax rates, and more recently, investment hype surrounding artificial intelligence.

He acknowledged that while passive investing offers individuals investors a low-cost way to build wealth, its collective scale has begun to distort broader market dynamics.

"... worryingly, market regulators believe in the purity of the benchmark and are potentially overlooking the growing systemic risk that it poses. This sets the stage for a disorderly market sell-off if flows into passive strategies reverse," he said.

"What appears good for investors in accumulation phase can be very detrimental for investors who, like retirees, are exposed to sequencing risk."