Passive strategies have been popular in recent years as investors have sought cheap and convenient access to stock markets. However, we believe they shouldn’t neglect actively managed funds – where the fund manager uses their knowledge and skill to find those companies that, in their view, should deliver a better performance than the wider market.
Passive strategies simply track an index, such as the S&P 500 or the FTSE 100 index, without attempting to pick the winners, or avoid the losers. They are generally lower-cost, with computers determining how much of each stock to hold.
Active strategies tend to be higher cost: that can affect any potential return, but we believe there are multiple reasons why it can be worth paying more.
1. Adding value
A passive strategy is only as good as the index in which it invests. An actively managed fund has the potential to make higher returns than an index.
There are multiple ways that an active manager can add value. They will meet company management teams, dig deep into a company financial metrics, including its cash generation, debt levels and growth rates. This helps them to identify companies where the current share price doesn’t reflect the inherent value of the company.
This research can be particularly valuable in certain parts of the market. While US and UK large cap stocks are widely researched, small cap equities and emerging market equities attract less attention. As such, there can be more mispricing for active managers to exploit.
Using the COVID-19 pandemic as an example, an active manager can shift their portfolio to benefit from the fast-changing world. They may buy positions in ‘lockdown winners’, such as Ocado or Zoom, while moving away from areas such as retail or hospitality. A passive index tracker cannot do this. Ocado returned 87% in 2020, but has less than a 1% weighting in the FTSE 100 index*. An active manager has the flexibility to take a far larger position. This is a similar case for specialised areas and themes, such as technology or healthcare. These may not be well-represented in an index, particularly if they are emerging industries.
Another reason to consider investing actively rather than through a passive strategy, is that an investment manager can tailor the fund to your particular needs. This may include your ethical preferences, which we mentioned in our last article, or any income requirement. Royal Dutch Shell and BP alone are approximately 8% of the FTSE 100 index*, not ideal if you would rather not invest in fossil fuels. Passive investing does not allow you to remove individual companies.
3. Risk management
There are also certain risks to be aware of when holding a passive fund. For example, a passive investment may not provide you with an appropriate asset allocation. Good asset allocation splits your portfolio into different asset classes: equities, bonds, alternatives and cash, which helps to balance risks. An index fund spreads risk across a single market, but will not determine the blend of assets that are right for you or adapt to changes in the broader market environment. This would be a key consideration for any active manager when constructing a diversified portfolio. It is possible to blend passive strategies, but there is not always sufficient choice to achieve a balance.
The majority of well-known indices are weighted by market capitalisation. That means investors are most exposed to the largest companies in a market, regardless of whether they are good companies – with low debt, good prospects, strong market share. This ‘size first’ approach ignores specific risks such as impending regulation or questionable governance. For example, 22% of the S&P 500 index is exposed to just five companies – Alphabet, Amazon, Apple, Facebook and Microsoft* – does this bet on technology really suit your risk appetite?
Active managers should be better placed to protect from downside risk because they are less constrained. A nimble active manager can react to short-term factors, be that economic or political conditions, or a pandemic. In the longer-term, active managers can avoid sectors in structural decline or experiencing considerable disruption.
4. Relationship building
Active management also comes with human interaction. This can be reassuring during tough times and can stop any rash short-term decision-making. You can talk to your manager about the best approach for your needs and discuss your investments if your circumstances change. A passive investment can’t provide this personalised approach.
Both passive and active funds can have a place together in diversified investment portfolios, depending on your time horizon and risk tolerances. Passive strategies certainly offer a cheaper and transparent way for investors to gain exposure to markets globally. However, quality of service and product vs the cost is a key consideration. Actively managed funds generally cost more, but there are multiple reasons why that might be a price worth paying.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
*Source: Thompson Reuters, 26.1.21
Investment does involve risk. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance. Rates of tax are those prevailing at the time and are subject to change without notice. Clients should always seek appropriate advice from their financial adviser before committing funds for investment. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable.
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This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.