InvestmentsApr 2 2020

Choosing active or passive 

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Choosing active or passive 

A feature of advice industry over the past decade has been the growth of assets into passive investment products, which simply track a market and deliver that level of return for clients.

As FTAdviser has previously reported, investors withdrew an average of £3.5bn a month from active funds since the introduction of the Mifid II rules in 2018.

Those rules increased the clarity around the true level of fees and charges paid by clients in a fund.

Equity bull market

But Gary Potter, who uses both active and passive mandates in the range of multi-manager funds he oversees at BMO Asset Management, believes the rise in demand for passive investment products coincided with the strong equity bull market which occurred in the years immediately after the, global financial crisis, 

Active fund managers prove their worth when conditions are more volatile, and that is why I think we will see a change now Gary Potter, BMOAAsset Management

Mr Potter said it is “logical” that if an investor thinks a market is going to rise by 10 per cent “they would buy a passive fund and just get that market exposure.

"But active fund managers prove their worth when conditions are more volatile, and that is why I think we will see a change now.” 

Net sales and funds under management at February 2020
 Funds under management Net retail sales
All funds£1,256.3bn£1,352m
Trackers£220.2bn£1,577m

Source: Investment Association

For Mr Seager-Scott, the decision on whether to use an active or passive fund comes down to how strongly he believes in the ability of the available active fund manager to beat the index. 

He says: “There is also a consideration for whether the market you’re looking at is one where there is a lot of scope for active managers broadly to add value, or whether it is a more simple or efficient market where there is less scope to add value.

"Since most active fund managers generally underperform an index, I think you should really have evidence-based conviction in your manager before using an active fund, and also be mindful of costs, as these are one of the few elements of performance that can be known with confidence in advance.” 

Mr Willis adopts the same view.

He says: “If the view is that a passive fund does provides us with the exposure we need then we conduct a  simple screen on what funds are available, what are they tracking, how well they do it and how much they cost. 

"Sometimes it makes sense to focus on the value you get and not just the price you pay.

"So if we have conviction on an asset class or equity market we may want to gain exposure through actively managed funds if we have confidence that they can add value.

"There are some areas where you cannot get a passive equivalent, such as UK smaller companies and absolute return funds. As such, an actively managed fund is the only option here.”

Tom Sparke, Investment director at GDIM, says his starting point is to ask if a passive fund could do the job, and if not, then he looks at active products.

He says: “Often we will have a style in mind and usually a shortlist to start from but we’d look at all the possible options fitting the criteria and delve deeper into those that could be selected.

"It is almost always the case that we hold a mixture of passive and active exposure in our fixed income holdings as diversifying in this space is very valuable and often an active approach to an asset such as sovereign bonds is not necessary.”

Ben Yearsley, investment director at Fairview, a consultancy firm, says he views some areas of the market as particularly unsuited to the passive investment style, and so focuses on other areas.

He cites bonds as an area where this unsuitability is particularly true. 

Information Ratio 

Charlie Parker, managing director at Abermarle Street Partners, says it is mathematically possible to calculate the asset classes where it is better to use active than passive, using a formula he calls the “information ratio.”

He says: “If you go back ten or fifteen years, and look at the top quartile of the best performing funds in an asset class, you can see that in many areas, even if you got it right, and actually managed to pick a fund that is in that top quartile, it wasn’t actually paying you enough extra return to justify taking the extra risk that comes with active management.

"What we found was that, if you picked the right UK small cap, or indeed all cap, UK equity fund, then the rewards compared with picking a tracker that invests in those asset classes are very high indeed.

"In contrast, we found that even if you pick the right US large cap equity fund, or gilt fund, then you weren’t really better off compared to the extra risk you are taking."   

Mr McDermott agrees that it is tough to find actively managed US large cap equity funds that justify the extra risk, and he citeds this as one of the few asset classes where he generally uses passive, as his default position is to use active funds. 

US large caps are more difficult than many other asset classes for an active fund manager to perform well due to the sheer number of investors who buy US equities.

The market is over 50 per cent of the total global listed equity market, so in addition to all passive global equity funds having very large allocations to the US market, there are very few actively managed global equity funds in the world that would have zero in the US, and then there are dedicated US equity funds.

All of those managers looking at a fixed number of stocks means it is relatively more difficult to find undervalued assets in that market.   

david.thorpe@ft.com