Investing passively could jeopardize your pension portfolio

By choosing the default passive investment path, pension savers may be sleepwalking into catastrophe

According to James Mackreides, this is a good time to assess your current situation.

Pension savers may be sleepwalking into disaster due to the rise of passive investments. Investment experts are becoming more concerned about the risks that many pension savers are unintentionally exposed to amid growing speculation about the possibility of a stock market correction or even just a protracted period of flat returns. Such risks have been made worse by passive investing.

In actuality, the majority of savers in workplace pension plans never actively choose their investments; according to Nest's employers' plan, over 90% of savers act in this manner, allowing their contributions to go into default fund strategies. These mostly rely on inexpensive index-tracking funds that merely track the market's fluctuations.

Even savers with self-invested personal pensions (Sipps), which provide greater control over investment options, appear to be choosing passive funds in large numbers, according to data. Index-tracking funds are among the most popular choices among these savers, according to data from websites like Interactive Investor.

Index-tracking funds and passive investments are problematic.

The issue is that index-tracking investments might be riskier than savers think. These funds don't simply follow the markets down when things are tough. The fact that many index-trackers are far more concentrated than is immediately apparent is the greater concern.

For instance, it sounds appealing to invest in a cheap fund that provides exposure to the MSCI World Index. It seems like you're getting a cheap way to invest in a variety of stock markets across the globe.

This is no longer the case in practice, though. According to a recent analysis by JPMorgan Asset Management, "While 20 years ago a passive investment approach provided well-diversified exposure, the same is clearly not true today." Because of the current shifting political and economic landscape, these benchmarks are now susceptible to certain risks."

The composition of market indices has been severely distorted in recent years due to the exceptional performance of a few major US technology companies. More than 60% of the MSCI World Index is currently derived from the US stock market, with the top ten US companiesmostly big techaccounting for more than 40% of that total.

To put it another way, investors with purportedly diversified portfolios are actually staking a sizable portion of their savings on a limited number of US tech companies.

In the meantime, there are comparable worries regarding bond markets, where the massive issuance of US Treasury bonds to fund the burgeoning US debt has had the same impact. These bonds currently make up the majority of fixed-income securities indices.

There are major effects. Investment strategies that divide pension savers' money into 60% stocks and 40% bonds are common; passive funds are used to secure these allocations.

However, JPMorgan's analysis indicates that savers who previously defaulted into or made such decisions now have very different portfolios. For instance, a 60:40 strategy that was introduced in 2008 would have divided equity and bond holdings appropriately, allocating about 40% of the entire portfolio to the United States and the remaining portion to markets around the globe. However, due to changes in the market since then, that portfolio would now have 55% of its investments in the US and over 80% of its exposure to stocks.

Even worse, according to some financial experts, passive investing raises the possibility of a significant stock market meltdown. They contend that passive funds push some companies to unsustainable valuations by inflating demand artificially, making the bubble's eventual burst inevitable.

In summary, if you have neglected your pension portfolio for years and have chosen default, passive investment strategies, there may be a lot of hidden risks. This could be a good time to see where you stand.