How to assemble the key parts of a passive portfolio

In constructing a portfolio that incorporates passive vehicles, investors have a number of considerations, which include deciding where to take active risk and the type of passive exposure that is most appropriate to them.

Where to take risks will involve both a strategic and tactical asset allocation decision. On the strategic side, investors have to decide if there are some markets they believe are inherently better suited to passive. For example, Peter Sleep, senior portfolio manager at Seven Investment Management, says: “In selecting the fund, investors have to think how broad the market is and how much latitude a manager has. In gilts, say, all a manager has is gilts.”

Gary Potter, joint head of multi-manager at F&C Asset Management, says he tends to use passive funds in the US and emerging markets in the group’s lifestyle portfolios. Mr Potter says proof of consistent outperformance by active managers in both areas remains relatively weak.

He adds: “It all depends on the diffusion of the market: in the UK, roughly 55 per cent of the index is in the top-10 stocks. There is lots of risk in focusing on those stocks. However, in the US, only approximately 4.8 per cent of the index is in the top stock – Apple – so there is greater natural diversification in adopting a passive approach in the US.”

There are also tactical considerations when deciding on what parts of asset allocation should be fulfilled by such funds. For example, in declining markets passive funds offer little protection.

Mr Potter points out passive funds can also be vulnerable to large shocks from one company – BP, for example. But active funds may also struggle to keep pace in rising markets. This can be seen most recently in Japan, where the Nikkei has risen 54.4 per cent in the past year. But active managers have struggled to keep pace, with the average fund in the IMA Japan sector up just 27.6 per cent.

Once investors have decided where they will take active risk, they will need to decide the type of passive exposure. Developments in the exchange-traded fund (ETF) market mean investors can be increasingly granular in their choices. For example, there is an increasing range of ETFs weighted on different criteria, such as dividends or sales growth.

Investors will also need to consider whether they would prefer passive to be the ‘core’ of their portfolio, and then use funds striving to generate long-term alpha as their ‘satellite’ holdings. Or, they may choose to have an active fund manager overseeing their core holdings, with ETFs on higher volatility asset classes around the edges.

The debate on active and passive exposure within portfolios has moved on, with many investors recognising that each has its place in a portfolio. However, that place may change over time, depending on the prevailing market conditions and characteristics.

Cherry Reynard is a freelance journalist