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Active v’s Passive Fund Management – ‘The Debate’ which is best?

One of the most enduring debates in the world of investment management is that between active and passive management. Which one provides clients with the best outcomes?

 Active management

Active managers build portfolios by choosing to invest only in companies that they believe will outperform their peers, also known as ‘stockpicking’. Active managers use a variety of techniques to decide which companies to invest in. In some years active managers will outperform and in others they will fail to achieve their benchmark.

 Passive management

Passive managers take a more systematic approach. They try and replicate a market or index by buying each stock in proportion to its market representation. There are different approaches to passive management along the theme of market replication. Supporters of passive management believe that markets are efficient and in general terms a Company’s share price reflects its true value, so there is little to gain from active stock picking. Let’s look at the key areas in more detail.

 Cost

Costs are almost always higher with active managed funds as there are additional costs associated with research and analysis. Conversely passive funds have lower costs due to the fact that the investment process is ‘systemised’. Cost is a key factor as an expense ratio of 2-3% on an active fund will have greater impact on the overall return than a passive fund with a lesser charge.

Performance

Here’s the big question, which one produces better return for investors? Unfortunately there is no clear answer to this, otherwise we wouldn’t be having the debate! The benefit of passive management is that the performance risks are more manageable as they will be closely aligned to the sector in which they invest, therefore eliminating a nasty surprise if the investment manager gets it completely wrong.

 By its nature it’s true to say that with passive management you will never significantly outperform your market benchmark. However, it could be argued that you are more likely to achieve your long term objectives with a passive approach as the degree of uncertainty is lessened.

 Risk

There is increased risk with active management as not only is there market or sector risk, but also the risk of the manager under-performing. Passive funds are not without risk. In addition to the inherent market risk there is also an element of manager risk as not all tracking methods are the same. Some will replicate the whole market, others will sample only a proportion of the index. As with active funds, the timing of buying and selling can also affect performance.

 What do the academics think?

There have been numerous studies comparing the two approaches. Academics tend to sit on the side of passive management, often quoting the ‘efficient-market hypothesis’; the basis of which is that generally market prices reflect all market information, therefore it’s impossible to systematically ‘beat the market’.

Summary

The key advantage of active management, the potential to beat the market, is only useful if you can consistently select the winning managers. There is no systematic way of ensuring this is the case as future manager performance cannot be predicted. However, some investors want to take additional risk in exchange for the chance of achieving a higher return.

When a passive fund is used you know in advance that you will be achieving a return that is approximately in line with the sector or market it’s tracking. This approach is one that is favoured by many advisers who are focused on helping clients achieve their investment goals with the minimum amount of risk.

The debate will continue amongst advisers who often have a preference for one or other methodology.  At Concept Financial Planning we do not have a preference for one over the other, what is important is the asset allocation decision, which we believe returns the majority of investment performance in a portfolio.  We use both methodology when selecting how to invest in the asset classes, as we believe a blend can give you the best of both worlds.  If you are looking to invest in UK equities and looking for dividend income can a index tracker fund provide you with this? Similiarly, why pay for active management on a gilt fund, when the cost can normally outweigh the addition return needed.

What is important however, and is crucially more the case with regards to active management on your portfolio, is that your investments are reviewed on a regular basis, this should include your risk profile and time scale for the investment to ensure that the asset allocation remains suitable and aligned to your financial goals.

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For more information on our Investment Management Philosophy and Process

Protecting Against Short-Term Risk

*Guest Blog by Colin McInnes @ Quartet Capital Partners LLP 

MY ASSET ALLOCATION – PROTECTING AGAINST SHORT-TERM RISK 

It still surprises me the extent to which private client investment firms ignore managing clients’ asset allocations on a dynamic or tactical basis and believe that fund or stock picking is the way to drive performance. To our mind, asset allocation is the biggest driver behind investment performance and is a key component of Quartet Capital’s investment offering. This is where we seek to add value for our clients. 
Currently we are living in a very unstable macro environment. The biggest influences on returns are the extent to which geopolitical factors will influence market sentiment; whether we are entering an inflationary or deflationary environment; and does the recent pullback in global equity markets spell the end of the recovery started several months ago? 

Our view is that we are just going to have to get used to political intervention – be it with Germany limiting short-selling or Europe muddling through the EU banking stress tests. This intervention will inevitably lead to higher levels of volatility as skittish investors focus on the latest news.

In terms of the global economic recovery, we view the data coming through in the UK, Europe and US as worrying and have increased our fears that we may suffer a double-dip recession. We remain concerned that markets are still in a long-term cyclical bear market and view the drop in risk asset prices as a healthy correction to markets that had spiked.

Until global price/earnings ratios are in single digits, we fear more downward lurches. If the economic recovery does gain traction, this market setback may create short-term buying opportunities, primarily in equities although corporate debt also begins to look interesting. Corporate bond spreads have widened but more as a result of government debt prices rallying strongly. Despite the rally in conventional government debt, we have maintained a large exposure.

This has been done for two main reasons. First, we remain fearful of deflation and are in agreement with the Monetary Policy Committee that UK inflation will quickly reverse in the second half of the year. Second, with big macro risks around, government debt has benefited from a flight to safety. To further protect portfolios, we hold a position in physical gold as a form of disaster insurance.

Elsewhere we have little BRIC, Asia or emerging market exposure due to our concerns that these markets are overvalued and offer little upside on a risk-adjusted basis. We also have no exposure to Europe – either currency, debt or equities across our sterling or US dollar accounts. But we are getting more positive about the prospects for Germany due to its large export sector and we might allocate funds there while hedging out currency exposure. In other currencies we maintain a significant exposure to the US dollar and despite the recent rise in sterling, view the dollar as being the lesser of two evils.

In relation to other assets classes, our hedge fund and absolute return positions have held up well and we remain positive on the outlook for volatility-based investment strategies. We hold two ‘special situation’ positions in the UK commercial property sector. We fear that limited upside now exists in the sector but special situations by their nature should not require broad market catalysts to come to fruition. We also hold a position in a ‘busted’ structured product that should produce a gross redemption yield of around 15% over the next 18 months.

Recent launches look uninspiring due to current interest rate levels but decent opportunities exist in the listed secondary market if one can accurately price the underlying constituents of the structure and can get comfortable with counterparty risk.

To conclude, we are pretty worried about short-term risks and have positioned portfolios accordingly.

We hope to be surprised on the upside.

Colin McInnes Bio

 

 Quartet Capital Partners LLP
 

 

 
 

 
 
 


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