Passive investments could put your pension portfolio in danger

The growth of passive investment means pension savers could be sleepwalking into disaster. Amid growing speculation about the potential for a stock market correction – or even just a prolonged period of flat returns – investment experts are increasingly worried about the risks many pension savers are unwittingly exposed to. Passive investment has compounded such dangers.

The reality is that most savers in workplace pension schemes never make an active investment choice – the employers’ scheme Nest says more than 90% of savers behave this way – leaving their contributions to flow into default fund strategies. These largely rely on low-cost index-tracking funds that passively follow the market up and down.

Data suggests that even savers with self-invested personal pensions (Sipps), which offer more control over investment choices, are also opting for passive funds en masse. Data from platforms such as Interactive Investor repeatedly shows that index-tracking funds are among the most popular options with these savers.

The trouble with passive investment and index-tracking funds

The problem is that index-tracking investment may be riskier than savers realise. It’s not just that these funds automatically follow markets down in challenging periods. The bigger worry is that many index-trackers are far more concentrated than is immediately apparent.

A low-cost fund offering exposure to the MSCI World Index, for example, sounds attractive. You’re ostensibly getting a cheap way into a spread of investments on stock markets worldwide.

In practice, however, this is no longer the case. “While 20 years ago a passive investment approach provided well-diversified exposure, the same is clearly not true today,” points out recent analysis from JPMorgan Asset Management. “These benchmarks are now vulnerable to very specific risks inherent in today’s shifting economic and political tides.”

In particular, the stellar performance of a handful of the large US technology giants in recent years has completely skewed the make-up of market indices. The US stock market now accounts for more than 60% of the MSCI World Index; within that allocation, the ten largest companies on the US market – mostly big tech – account for more than 40%.

In other words, investors with supposedly diversified portfolios are actually betting a very large chunk of their savings on a small number of businesses in the US tech sector.

There are similar concerns, meanwhile, about bond markets, where the huge issuance of US Treasuries to finance the mushrooming US debt has had the same effect. These bonds now dominate indices of fixed-income securities.

The impacts are significant. Pension savers are often invested via strategies that split their money by holding 60% in equities and 40% in bonds, with those allocations secured through passive funds.

But JPMorgan’s analysis suggests savers who made such choices – or defaulted into them in the past – now have portfolios that look very different. A 60:40 strategy launched in 2008, for example, would have split equity and bond holdings accordingly, and allocated roughly 40% of the total portfolio to the US, with the remainder spread in markets across the rest of the world. But market movements since then mean that portfolio would today be more than 80% exposed to equities and 55% invested in the US.

Even worse, some investment experts believe passive investment increases the risk of a major stock market crash. By artificially inflating demand, passive funds drive some companies to unsustainable valuations, they argue, with the bursting of the bubble eventually becoming inevitable.

The bottom line? Your pension portfolio may be full of hidden dangers, particularly if you’ve left it alone for years and opted for default, passive investment strategies. Now might be a good moment to check where you stand.

This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.