Active versus passive – why not use best of both?

When buying investment funds there are two main options, active and passive, but how they can complement one another in a portfolio?

| 5 min read

There is one debate in fund management circles that never seems to end: whether an active or passive approach is best. A quick reminder, active funds employ managers to try and select the best performing investments, whereas passive investments – or ‘trackers’ – simply aim to replicate the performance of an index, say, the FTSE 100, usually by holding all or most of the constituents.

Many industry professionals are staunch advocates of active investing, claiming that a selective approach leads to better ‘risk-adjusted’ returns. They also make the point that passive strategies are effectively getting a ‘free ride’ on markets. ‘Price discovery’ is achieved through the research of active investors, whereas passive investors simply buy the market paying no heed to valuation nor prospects. Meanwhile, passive enthusiasts point to the high failure rate of active strategies, and urge that investors should maximise returns by minimising costs – something that is easy to do with inexpensive tracker funds.

Our view is nuanced. We believe there is a place for both types of investment in portfolios and there is no need to wed yourself to one approach or the other.

Passives should generally be considered the ‘default’ option in the absence of a genuinely strong reason to use an active fund. Trackers represent a particularly good strategy for areas where managers consistently struggle to beat the index – often large, well-researched markets. The US market would be a prime example and investors will have done well in recent years simply to buy an S&P 500 tracker. It is worth noting that the inexorable rise of a cluster of large tech and e-commerce businesses has overwhelmingly driven the US market, and should these have a tougher time then a standard passive fund could struggle. However, in the absence of a crystal ball and in recognition that it’s really difficult for an active manager to consistently have an edge over Wall Street, passive funds remain a strong option for this market.

Yet there are also areas where we would hesitate to take a passive route. UK smaller companies is one area where active managers have added considerable value over the years. Over the past decade, the average fund in the Investment Association UK Smaller Companies sector has turned £1,000 into £3,670 whereas hugging the widely used benchmark index, the Numis Smaller Companies Excluding Investment Companies, would have resulted in £3,081. Why is this? We believe it’s the ‘inefficiency’ of the market. Relatively little proprietary research is taking place compared to the multitude of analysts poring over US behemoths. Fund managers getting under the bonnet of these businesses are more likely to discover anomalies and opportunities missed by others.

Uncovering stocks or areas that the wider market doesn’t fully appreciate is precisely where active management works best and cost, although important, may be a second order consideration. Often more pivotal to returns is the expertise of the manager and their team.

At Charles Stanley, our managers building portfolios are neither wedded to active nor passive strategies for fund choices and can cherry pick the optimum strategy for particular needs. Presently, portfolios are positioned about 60/40 passive to active, but this ratio changes over time. If they think there are more inefficiencies for active managers to exploit, they allocate more towards active. We are currently investing in active funds in Asian and Emerging Markets where we believe there is more opportunity for active managers to add value, whereas in developed markets we are more biased towards low-cost passive funds outside some more thematic strategies. Private investors populating their own portfolios can take a similar approach.

There are also investment frontiers beyond the reach of passives that are well worth considering for diversification. For instance, ‘illiquid’ areas such as physical property and infrastructure can be accessed through specialist investment trusts. The ‘closed ended’ structure of an investment trust is often most appropriate for accessing esoteric asset classes, and the only credible option for areas where liquidity (the ease of buying and selling the underlying investment) is problematic.

Private equity is also a major area where active management is largely the only route – and this could be an Achilles Heel of passive-only portfolios. Stock markets don’t have the monopoly on investment opportunities. On the contrary. Some of the fastest growing companies and investments with exciting potential are in the hands of private holders, often founders and exclusive bands of early investors in the case of relatively new companies. Private equity investment trusts buy into unlisted companies and other areas that would otherwise be very difficult to access. Although it can be higher risk, its potentially a source of decent returns as sometimes the growth a company enjoys is strongest in its pre-stock market life – if it ever lists on a market all. There are also some broader trusts that include an element of private equity in their portfolios, including Scottish Mortgage, an adventurous global growth trust and RIT Capital Partners, a more diversified ‘multi asset’ Trust.

By combining passive funds in more generalist areas with more specialist active funds, pragmatic investors can take a ‘best of both’ approach. This should result in genuinely diversified portfolios that maximise opportunity as well as control cost. There is no need to wed yourself to one side of the active versus passive debate.

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.

Active versus passive – why not use best of both?

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