The passive market has grown exponentially over the past decade and in recent years, many investment columns have been devoted to the so-called ‘active versus passive’ debate.
Those in favour of actively-managed funds highlight that fund managers can take advantage of investment opportunities as they arise, in addition to those created by market volatility. In contrast, they claim passive funds have little flexibility to ‘swim against the tide’ and therefore guarantee underperformance (after fees).
The passive cohort, however, highlight the reams of academic studies that show a large portion of active managers underperform the market and there is the perennial question of fees.
In our opinion, it is not about choosing one side over the other. We believe the active versus passive debate is outdated because it is not a binary decision to invest in an actively-managed fund over a tracker fund, or vice versa.
For us, it is simply about selecting the most appropriate investment vehicle that will achieve the best outcome for our clients.
Initially, we make an asset allocation decision such as increasing exposure to a specific part of the market because it looks attractive. We then assess both the active and passive opportunities and carefully analyse the most suitable one for the client depending on their risk profile and objectives.
As an experiment, we created a ‘passive-only’ portfolio in line with our asset allocation views. We wanted to explore how this control portfolio would compare to the typical portfolios we manage for clients (which include both active and passive funds) in terms of cost, performance and investment outcomes.
Although our research is ongoing, an important caveat is that there are some parts of our typical client portfolios that cannot be replicated passively. As soon as you move away from traditional asset classes, you run into challenges.
For example, it is difficult to replicate commercial property indices as you cannot buy a bit of every building in the benchmark, just as it is very difficult to buy a small share of a series of infrastructure projects.
Likewise, hedge funds and absolute return funds provide investors with the prospect of some protection when markets fall, however it is difficult to find a passive equivalent, although there are funds that use algorithms to replicate successful hedge fund strategies that could be classified as passive.
Even in more conventional areas, we have concerns about the passive options available. The bond market is likely to face numerous challenges, as central bank monetary policy starts to normalise, and we are concerned that liquidity could be a problem.
The growing use of passives has also unwittingly created investment opportunities for savvy active managers as they understand how passive fund flows behave if markets come under pressure. This creates opportunities for managers to go against the crowd and react quickly to market inefficiencies.
Each market comes with its own set of dynamics, which means that active managers have historically performed better in some markets than others.