Active vs passive investing: how the debate stacks up
The active vs passive investing debate shows no sign of abating and can sometimes seem one-sided. But is there a case for both in your clients’ portfolios and, if so, how do you strike the appropriate balance?
A quick re-cap on active vs passive investing
Active managers make investment decisions in an effort to outperform their benchmark, while passive managers track an index to gain exposure to a market or segment of a market.
So what drives performance?
In simple terms, the performance of a portfolio of investments is made up of components termed beta and alpha. Beta is a measure of how a portfolio or an individual investment moves (on average) when the overall market increases or decreases. It also provides insights into how volatile or how risky a portfolio or individual investment is relative to the rest of the market. Alpha, on the other hand, is the excess return of a portfolio or an individual investment after adjusting for market related volatility. This represents the additional value a fund manager can add to the performance of a portfolio through stock selection. One of the main reasons why you might consider investing with an active fund manager, rather than in a passively managed portfolio, is this potential for outperformance through alpha creation, although this is not guaranteed. By taking positions away from the benchmark there is also potential that a manager may underperform.
The case for passive investing
The benefits of each strategy continue to be debated and in certain asset classes, there is a stronger case for investing passively.
The US market for example is characterised by high levels of institutional ownership, particularly by home grown institutions which are more familiar with domestic securities. When a market has large numbers of professional investors, who all have access to the same publicly available information to help them value stocks, it makes it less likely that individual stocks will be significantly overvalued or undervalued. Markets like this with fewer mispriced opportunities are described as being ‘efficient’ . In contrast, emerging markets are comparatively ‘inefficient’ as they can provide a higher level of mispriced opportunities. The range of investment opportunities in emerging markets has changed dramatically over the last 30 years; many of these markets are still under-researched in comparison to developed markets. This provides an opportunity for a fund manager and team of analysts to uncover attractive investment opportunities before these are reflected in market prices.
Finding the right strategy for the right market
Understanding market efficiency and separating efficient markets from those that are less efficient helps you to make an active decision on whether to employ active or passive managers in different sectors of a portfolio.
Source: Wikipedia 2019
When you want exposure to an efficient market it can make sense to do this through a low cost index tracking passive investment. Before selecting an active manager to provide exposure to an inefficient market, you need to have conviction that their investment process can deliver above market average returns and justify the additional fees.
Ultimately, both active and passive strategies have a place in portfolios and it is in the interest of investors to strike a balance between the two and use each method when and where it is most appropriate.
It’s always an active decision
While it is important to consider the merits of active vs passive investments in each area of the market, it is equally important to continually re-appraise our decisions. At Schroder Investment Solutions, we use economic cycle analysis to dynamically allocate between active and passive investments at both an overall portfolio level and within each asset class. We evaluate the state of the global economy using a broad range of data components to track global activity trends. When the data indicates a negative outlook and a slowdown in the economy, investors typically benefit from a larger allocation to active managers and vice versa.
The Schroder Blended Portfolios are part of our Schroder Investment Solutions range. The Portfolios are independently rated, actively-managed multi-asset funds that capture the best of active and passive investing. By actively allocating to the best-in-class of both investment styles, we deliver appropriate client investment outcomes, at a cost that offers real value for money.
Find out more
Download our client-facing active vs passive infographic here.If you would like to find out more about the Schroder Blended Portfolios, simply visit schroders.com/investment-solutions, contact your usual Schroders’ representative or call our Business Development Desk on 0207 658 3894.