Flaws in active/passive debate - part 2

As will be obvious to our readers, a battle is still raging in the retail finance world between advocates of actively managed or passively managed investments.

Although passively managed funds seem to be winning the battle at the moment, I argued in my column last week the whole controversy was flawed. Furthermore, I promised to give some examples this week of how active investment managers could repitch their services to balance the debate. In fact, there are so many examples I’ll be writing about them over two weeks at least.

The first way active managers can repitch their services is by speaking out against the terrifying notion that asset allocation can be passive. Passive asset allocation dictates that there is a set approach to picking assets to meet clients’ goals, and all advisers need to do is follow it passively.

By definition, we cannot know what combination of assets will work in the future. We cannot perfectly predict conditions in the markets for those assets. The only way of deriving a “perfect” allocation is by looking at what combination of assets worked “perfectly” over conditions in the past and assume those will apply in future.

This latter principle ignores all the rules of financial analysis. Past performance is not a sole guide to the future. Many would say it is no guide at all. And yet the entire UK and European funds industry is being shovelled into this trap of “passive allocation”.

If they are regulated under the EU’s new Ucits IV fund directive – and the vast majority of them are – UK retail funds have to assign themselves a “synthetic risk reward indicator” or SRRI. The SRRI is a number from one to seven that is based purely on the past performance and volatility of an asset class. In other words, equities are higher-risk, bonds are lower-risk and government bonds are the lowest risk of all. Investors will be naturally cautious after the events of the last few years and are more likely to opt for the lower-risk categories. They may find these are not particularly low-risk after all.

Take the IMA’s ‘lowest-risk’ mixed asset sector as an example – Mixed Investment 0-35 per cent Shares. The SRRI places many funds in this sector in roughly the middle of its range of risk. If this low-risk sector is in the middle of the range, to make the lower end of the range you must be invested purely in bonds – most likely issued by governments or investment-grade companies, whose debt is often priced in relation to government bonds. For those who say we may be in a government bond bubble, it is terrifying that the EU is labelling these pure fixed income funds ‘low-risk’ – even in spite of the ongoing problems in eurozone government debt markets.