Understanding the role of active and passive investing

Understanding the role of active and passive investing

Embracing Passives: the power of active decision-making

Wednesday 13 September, 2023

There are compelling arguments on both sides of the active versus passive investment debate when it comes to portfolio construction. A benefit for one can be a drawback for another, which is why we believe there isn't a right or wrong choice.

Whilst passive or ‘tracker’ funds involve following the market, active investing is a strategy which has an appointed fund manager with research, selection, trading of securities and ongoing monitoring of the fund. We believe these two styles of investing do not need to be mutually exclusive when constructing and managing portfolios, and we prefer to provide clients with the best of both worlds. 

What are the benefits of blending passive funds into a portfolio?

Passive funds have the benefits of broad market exposure, market-like returns, style agnosticism and low costs. US or global large cap equities are a good example of markets where it is difficult to find managers who consistently outperform the benchmark over a long period of time. These indices will ordinarily have a growth bias, which can be complimented with a quality or value style active equity manager. 

Given the lower management fees, selecting passive funds where we believe an active manager cannot achieve meaningful outperformance has a higher potential to translate into higher net returns for clients. As passive funds do not make active stock selection, instead replicating an index of assets, they can provide exposure to a whole market. Passives tend to be style agnostic given their broad market coverage, which can be blended with selected stylistic active managers. This means returns for passive funds are closely mirrored to market performance and volatility akin to the benchmark, which helps achieve an overall smoother client journey when blended with active managers who can be more volatile than the market across certain time periods.

Why are active funds still important in a portfolio today? 

Active investing involves managers having the freedom to pick what to invest in, according to their defined strategy, and the value add from this freedom is the opportunity to outperform a benchmark. We give an ultra-wide remit to the managers we believe to be these winners and have complete trust in their stock selection capabilities. We choose some active managers based on their ability to pick the best companies within their investible universes with the strongest growth characteristics, other active managers are selected in accordance with their known approach to risk; be it be it valuations or downside protection, whilst several are chosen because we know they run low volatility funds or do not take risks on high valuation companies for example.

Business cycles are an important factor to consider in active fund management 

In a difficult economic environment there tends to be a dispersion between the ‘good’ and the ‘bad’ companies. This is where the value in holding active managers becomes more important as they are the ones who have the freedom to stock pick the winners. Passive funds will hold these quality names, but they will also have exposure to other companies which may not be as resilient in this environment. 

Research by Invesco[1] supports the notion that active investments are better at weathering negative or downward performing markets. They generally provide more attractive risk-adjusted returns too. Research suggests that for each unit of volatility risk taken, active managers reward you more over the long term. 

The market in question must also be taken into account 

In less efficient markets (e.g. emerging markets) or areas where there is less readily available information (e.g. small caps), it is important to own managers who know these sectors or more niche areas and can make well versed decisions.

Active managers have the ability to identify opportunities 

Active managers can exploit market inefficiencies and arbitrage opportunities, which passives are unable to do. Active fund managers can add to quality businesses on market weakness and they can continue to evolve in terms of identifying where the opportunity set lies.

Striking a balance

We firmly believe in the value of active management for achieving long-term outperformance and managing portfolio risk, whilst passive strategies can offer stability and lower costs. A “blended” approach allows us to carefully select which sectors, geographies, and allocations are best suited for passive investing, while maintaining active management for areas where it truly adds value. We believe this offers clients the best forward-looking approach, and portfolios which can benefit from short term and long-term market trends.

[1] https://fpamn.org/wp-content/uploads/Invesco-Active-Outperformance-WhitePaper.pdf

Risk warning

This communication is issued and approved by Lonsdale Services Ltd. It is based on its understanding of events at the time of the relevant preparation and analysis. The information and opinions contained in this document are provided by Lonsdale and are subject to change without notice and should not be relied upon when making investment decisions. The value of your investments and the income from them may go down as well as up and neither is guaranteed. Investors could get back less than they invested. Past performance is not a reliable indicatorof future results. 

Changes in exchange rates may have an adverse effect on the value of an investment. Changes in interest rates may also impact the value of fixed income investments. 

The value of your investment may beimpacted if the issuers of underlying fixed income holdings default,
or market perceptions of their credit risk change.There are additional risks associated with investments in emerging or developing markets. The information in this document does not constitute advice, nor a recommendation, and investment decisions should not be made on the basis of it. The material provided should not be released or otherwise disclosed to any third party without prior consent from Lonsdale.

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