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A bit of active and a bit of passive investing makes sense

There has been an on-and-off debate about active and passive management for many years. But is there a right answer?

There has been an on-and-off debate about active and passive management for many years. But is there a right answer?

by
John Redwood

in Features

21.05.2020

The discovery that many fund managers did not manage to beat the equity index for the country in which they were invested, led to the creation of funds that replicated or mimicked the index. They give you the capital gains and income of your share of the totality of shares in a given market, minus a small amount for the costs of the fund. This has led some to conclude you should buy the passive, to avoid the danger that your chosen investment manager underperforms the index. It means surrendering the hope that they will do better than the index.

The debate about whether someone should be an active or passive investor is a false distinction. It may make good copy for investment articles in papers and magazines, but it offers little insight into the decisions savers and investors have to make. In reality, there is no such thing as a purely passive investor, nor are many active investors active about all elements of their investments. The more prosaic reality is most investors are partly active and partly passive in their portfolios.

Complexity

There is no such thing as a purely passive investment.  If you want to invest by matching market indices, you first have to make some very active decisions about your portfolio. Which asset classes do you want to include? Do you want some in shares, some in bonds and some in property? When you decide on shares, do you want that to be the world market, or your national market, or some choice of individual geographical markets?  If you want some investment in bonds, do you choose government or company loans? Which country or countries do you want in your portfolio?   If you like property do you have enough money to buy individual properties, or are we talking about a property fund or a portfolio of property company shares?

At Charles Stanley, we always point out that you do need to decide on an asset allocation, which is the most important decision you will make that has an impact on your performance. Some think once decided you should live with it for the long term, but usually, it is better to keep it under review in case there is a major change in your needs or market behaviours that would warrant altering it.

Just deciding your asset allocation still requires active choices to implement it, even when deciding on low-cost passive funds. Say your chosen asset allocation includes US shares. Do you want to match the S&P 500 Index, the Dow Jones, or the Nasdaq? Do you want an index that includes all listed companies, just the main ones or just the smaller ones? These are all available as index funds – and will deliver different results. If you have made a choice, do you want to stay with it whatever happens, or do you want to try to make changes if fashions and perceptions about the different US markets change?

The nearest you can get to a purely passive portfolio would be to set up say a risky portfolio that simply copied the World Index or a balanced fund that had half invested in a global share index and half in a global bond index. Your investments would be managed and changed by the index manager, taking new companies into the index as they qualified, expelling failures from the index when they crashed, and adding to positions when companies expanded their share base. Every day, you decide not to meddle with the original asset allocation decision you are effectively making an active choice.

Both useful tools

Today much investment management uses a bit of active and bit of passive investment. There are so-called dynamic passive funds and portfolios. Here the investment manager seeks to add value by changing the asset allocation as market opportunities and risks present themselves. They use passive funds to implement the strategy to cut the costs of management of the individual share and bond holdings. There are largely active funds where the manager decides the asset allocation and chooses individual investments to implement it, but sometimes uses a passive fund for an exposure where it offers an easy and cheap way of getting the exposure wanted.

The same argument applies to active investing. Some think they are active investors because they ask a portfolio manager to manage a portfolio of UK or world shares for them, choosing the ones that might perform better than the index. If the individual stays with such a portfolio, they are taking a passive approach to the most important decision of all, whether they should have a portfolio of such shares in the first place rather than some bonds or properties or shares elsewhere in the world.  In order to be truly active, they need to review the asset allocation and switch as conditions and needs change.

Like many of the debates in investment, there are no wholly wrong answers and no single right answer. If you find a great investment manager who is on form at asset allocation and share selection, then it makes sense to let him or her free to make all such changes to a portfolio. If you want to limit costs a bit, it is probably wise to spend your fee money mainly on asset allocation which has the biggest impact on results. You need an asset allocation whatever your theory of investment. If you decide to keep the same asset allocation for the long term that is still an active and important decision.

Active is important

We have just seen how important some of these decisions are to your wealth as we watch the upheavals from the Covid-19 crisis. So far this year, caution has been rewarded, but so has taking the risk of backing Nasdaq and technology shares. Most would agree that social distancing will induce substantial changes in the business world, with new winners and plenty of losers.

All this argues for having some active management of your money. Then it’s a question of how much you want to spend on management, and how many risks you want to take over currencies, markets and individual securities. The more active you are, the more risks you seek to manage. Your view may be gloriously right and so you multiply your gains by backing that same view over asset allocation, currency and share choice. It might be unfortunately wrong when the more features you have chosen mean intensifying the losses.

That is why investment managers usually advise people to have a portfolio which spreads their risks a bit. A good portfolio contains things in it that do not perform very well in the conditions being experienced in markets. They are there in case the underlying judgement about markets is wrong. They are there for when the market mood changes unexpectedly. 

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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