There is much debate over active versus passive investment, but the reality is that combining both w...
There is much debate over active versus passive investment, but the reality is that combining both within an asset allocation strategy can be the best approach - the question is when to use each.
The best parts within an asset allocation strategy to turn over to passive management tend to relate to developed stock markets, where active managers can often struggle to beat the benchmarks with much consistency over the long run. Large, transparent markets with daily pricing and adequate liquidity are the perfect environment for index funds to tightly track a market.
Conversely, the younger and more esoteric the investment market, the fewer indices are probably available for an index manager to choose from, making index trackers a potentially less effective route to harnessing the opportunities in those markets.
History shows active managers tend to do better in markets where qualitative research, country and security selection drive results and cap-weighted indices are less representative of the market. This is typically the case among the higher growth emerging markets, where active managers in aggregate have beaten the market every year over the last decade. A simple model to pursue for asset allocation in a broadly diversified, balanced portfolio is to index the element of your portfolio in developed markets, where the probability of underperforming the market is greatest, while focusing your active picks in areas where the potential for outperformance is strongest.
Within HSBC's range of multi-asset balanced portfolios, which contains some 16 different asset classes, turning the major developed markets over to trackers for exposure in developed stock markets has had the impact of significantly reducing the total expenses of the portfolio while limiting the potential for underperformance due to the dispersion among active managers in these markets. Turning developed stocks to passive equates to around 40% of the total assets being allocated thus.
If you believe developed stock markets will struggle to break out of single digits, the price you pay to access them through active management could look dear to your clients when they look back on their results. Using trackers could bank you as much as 1% of your assets in opportunity cost, just through the fees you save.
At the same time, if you believe active fundamental approaches can add value, using indexation for parts of the portfolio where the prospects of successful manager selection are lower is important. This has the effect of freeing up time for more research into broadening diversification and focusing the time dedicated to understanding managers in less efficient markets where the probability of choosing a manager able to deliver excess returns over the benchmark after fees is greatest.
David Chellew is head of UK wholesale marketing at HSBC Global Asset Management
