While the active vs. passive debate has raged for decades, the current bull market has many convinced that all passive portfolios can declare victory. But a closer look at the limitations of many passive strategies – in particular the market-capitalization weighting strategy most employ – reveals the debate is far from over.
1. The index may not be focused on fundamentals
The S&P 500 Index has underperformed – and potentially carried more risk than – Smart Beta approaches that weight securities by a company fundamental or simply by equal weight.
2. The index may not be as diversified as you think
Diversification? Actually, financials and smokestack companies dominate international equity, and state-owned enterprises are prominent in emerging markets equity.
3. Some indices don't screen for profitability
The traditional U.S. small-cap index actually has a high percentage of unprofitable companies.
1. The policies that drove the last 10 years are gone
Quantitative easing and zero interest rates, which propelled passive out-performance, are no longer present across most global markets today.
2. Valuations are rich, particularly in U.S. equities
The index may not be cheap in every sense. While index strategies often have low management fees, the valuations of the underlying securities matter too – and U.S. large-cap stocks are particularly expensive now.
3. Correlations between U.S. stocks and the index are lower
After the financial crisis, most companies traded in unison with the broad market, but correlations between individual companies and the broad index have been falling, and that has made stock picking more valuable.
Correlation expresses the strength of relationship between distributions of returns between two data series. Correlation is always between +1 and -1, with a correlation of +1 expressing a perfect correlation, meaning that the two series being compared behave exactly the same, a correlation of -1 meaning the two series behave exactly the opposite and a correlation of zero meaning movements between the two series are random.
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Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile. Eurozone investments may be subject to volatility and liquidity issues. Investments in securities of growth companies may be volatile. Mid-sized company stock is typically more volatile than that of larger company stock. It may take a substantial period of time to realize a gain on an investment in a mid-sized company, if any gain is realized at all. Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall, and the Fund's share prices can fall. Below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk. Diversification does not guarantee profit or protect against loss.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.
Carefully consider fund investment objectives, risks, charges, and expenses. Visit oppenheimerfunds.com or call your advisor for a prospectus with this and other fund information. Read it carefully before investing.
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