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 We believe the active versus passive debate is outdated because it is not a binary decision to invest in an actively-managed fund over a tracker fund, or vice versa.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.
Investigation
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.
Outcome
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.
Evaluation
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.
In UK equities, when reviewing peer group performance of rolling three year periods over the last ten years, the middle of the second quartile return outperformed the index for 94% of the monthly observations (assuming a 0.05% fee for the index).
In the US, this percentage fell to 30% and fell further to 20% in emerging markets.
The good news is that when using the top of the second quartile peer group return, the percentage of observations that outperform the index significantly increases. In the UK it amounts to 100%, 79% in the US and 89% in emerging markets.
Whilst these figures do support the merits of active management, they also do highlight the importance of selecting a good manager.
Selectivity and thorough research is crucial when it comes to deciding whether to invest with active managers, and the same is true for passives. Investors must develop a comprehensive understanding of where it makes sense to own both passive and active funds in a portfolio because both may have a place.
We will watch with interest to see how our passive-only portfolio performs from here. We are keeping an open mind and anticipate further developments in the world of passives. After all, nothing stands still in the world of investment.
Alex Baily is portfolio director for Cazenove Capital
This article is issued in the UK by Cazenove Capital which is part of the Schroders Group and is a trading name of Schroders & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Issued in the Channel Islands by Cazenove Capital which is part of the Schroders Group and is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission. Issued in Hong Kong by Cazenove Capital Management Asia Limited ("CCM Asia") of Level 33, Two Pacific Place, 88 Queensway, Hong Kong. CCM Asia is licensed and regulated by the Securities and Futures Commission. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.
