As the debate between passive vs active investing continues to divide opinion, a fine balance exists between the two, wherein it is possible to get a passive underlay with an active overlay. In such precarious times, balance is everything
It is time to move the traditional passive versus active debate on. The huge growth in the number of trackers and ETFs in the past couple of years has changed the investment world dramatically.
Investors need no longer be either passive or active – increasingly they are both. The real question investors are asking is how active they should be, or how passive?
At the root of the traditional active vs passive debate was the issue of value. That remains unchanged. Most investors need at least some help in building and managing an investment portfolio and they will incur fees for that help. The issue is whether they think the returns can justify the fees. And that is where opinion has historically divided – and where very recent product developments have changed the landscape dramatically.
In deciding how active you should be, it helps to look at where returns come from in an investment portfolio. One would expect the activity that leads to the most significant returns to be the activity most likely to justify its cost.
Research
Academic research has suggested over 90% of successful investment performance comes from asset allocation. That figure is debated, but no-one should doubt its importance.
The table on the right underlines this. It shows the performance of the major regional IMA equity sectors in the past three years. In 2009, on average, funds in the Global Emerging Markets sector grew by 57.7%. The average Japan fund fell by 3.4%.
For the fifth year in seven the worst fund in the best sector outperformed the best fund in the worst sector. We will come to fund selection (active or passive) later, but this data offers clear support for the argument that what matters most is where you put your money – and is the strongest argument any adviser might need for persuading a client that putting all their equity holdings into a FTSE All-Share tracker is madness.
Noone can predict with certainty which sector, or asset class will outperform. So investment wisdom dictates you should have a diversified portfolio. It is a matter of emphasis.
So the first challenge is to build a balanced portfolio with a strategic asset allocation that suits your client’s needs and is weighted towards those areas you think are most likely to deliver the target returns within your client’s risk parameter.
Beyond that, consideration needs to be given to the opportunity and risk benefits of actively managing the asset allocation – tactical asset allocation.
Winners and losers
The table underlines the opportunity for returns that can come from active asset allocation. Global emerging markets may have been the place to be in 2009. But in 2008 it was almost the worst-performing sector. Japan – last year’s dog – was the area that performed the best in the annus horribilis of 2008 (losing a modest 2.6% on average against UK Smaller Companies, which lost nearly 41%).
(The pattern of one year’s winner being the next year’s loser is oft repeated – UK smaller companies is a regularly sector that seems to be either one of the best or one of the worst areas to invest.)
Tactical asset allocation is harder than strategic asset allocation but these numbers show
that, if done well, it has significant potential to boost returns.
Selection debate
Finally we come to product selection. And this is where investors have traditionally split in the active passive debate.
Active fund management costs more. Unfortunately, the proportion of active managers who beat the relevant index consistently is disappointingly low. A significant number will underperform the index badly. But if you can select funds well the opportunity for serious outperformance exists.
The best-performing fund in the Global Emerging Markets sector last year delivered 78.66% against the sector average of 57.7%. In the UK All Companies sector, the best fund returned 101.4% against the sector average of 30.4%.
Passive funds on the other hand are much cheaper. Trackers almost never outperform but choose a good product with low charges and the margin of underperformance will be modest.
By choosing passive funds you minimise the opportunity for outperformance but reduce the risk of underperformance too, and that is what makes them attractive for the price.
Passive funds are usually very easy to move in and out of too (this can make them attractive to active fund of funds managers and discretionary managers who want to take a short-term position for tactical asset allocation purposes).
But you still have the challenges around asset allocation. And, increasingly now, because of the number of passive products on the market, passive investors have the problem of product selection. Trying to build a balanced, and diversified, global portfolio of trackers and ETFs can be time-consuming. They need to be chosen with care. Many underperform the index they are tracking; many cost more than they should; some are more complex than they seem on the surface; issues of counterparty risk need to be considered too.
Fund of funds solutions
Many IFAs who have leaned towards the active end of the spectrum see fund of funds as a solution to the problems of delivering strategic and tactical asset allocation and expert fund selection.
Our research has historically shown a good fund of funds manager should more than cover the extra costs and investors have had a better chance of picking a top-quartile fund of funds over five years than a top-quartile single-manager fund.
But headline TERs of around 2.25% mean those who lean towards the passive end of the spectrum have seen them as an expensive solution.
The launch of groundbreaking new passive-only fund of funds vehicles – with TERs under 1% – could change all that.
They bring a retail solution to the market that solves the main problems faced by a passive-inclined investor.
As we have shown above, passive investing is not simple – you still need asset allocation and potentially tactical asset allocation. You still need fund selection, and you have to pay for it.
The challenge is to buy in the expertise cost-effectively.
Using a passive-only fund of funds it is now possible to have all that at a price that represents real value to the investor – you get a passive underlay with an active overlay. And for many, that is the perfect balance.
Philippa Gee, head of marketing and communications, T. Bailey
