Passively-managed vehicles such as exchange-traded funds are increasingly featuring in investors’ portfolios, but there is a danger clients may be lulled into a false sense of security and strong asset allocation is still important for delivering returns, according to a white paper from Momentum Global Investment Management.
The report, issued in conjunction with the Scorpio Partnership consultancy, said that in the last three years, more than half of wealth advisors had introduced a passive investment approach in clients’ portfolios.
The debate on whether “active” or “passive” investment management is best is a constant theme in wealth management. With active management, where people pay a higher fee to a manager in return for acquiring market-beating returns, it is argued this approach is less effective in large, efficient markets where mispricing is harder to sustain; passive management is a lower-cost approach.
The issue of what is the most cost-efficient way for investors to express their views in a market comes at a time when the issue of costs and fees is rising up the agenda. The UK reform program to financial advice – the Retail Distribution Review – is forcing managers to be more transparent on their fees and encouraging some advisors to farm out discretionary wealth management. The issues are complex – there is no “right” or “wrong” answer to what is the most suitable way to invest, the report said. “Whether to go active or passive is just one decision when managing a portfolio. This decision is an output of a much larger decision tree, and for us is very context-dependent,” the report said. “Essentially, the active versus passive debate for us is partly an implementation question. We aim to find the most efficient way to get the exposure that we want. At times the most efficient way might be to use passive strategies, while in others the best route may be active management,” it said.
On asset allocation, the report argued that “going passive” requires investors to get asset allocation policy correct.
“A passive solution may not save you from market crashes. Whether you are in an active equity fund or a passive equity fund, if markets fall by 20 per cent you are likely to suffer material and painful losses,” it said.
The report also argues that while passive investing is generally less expensive than active investing, this is not always the case. In the credit markets, such as in high yield and loans, passive can often be more costly. The costs of an active portfolio in loans ranges from 40 to 100 basis points, compared with an average of 83 per cent for passive funds.
With passive funds, cost issues can arise depending on the nature of an index that a passive vehicle tracks. For example, the report said that hedge funds arbitraging the rebalancing and membership of an index such as the FTSE index comes at the expense of performance of passive strategies. A strict tracker fund must buy stocks after they have appreciated and sell others after they have fallen.
By WealthBriefing, MGIM White Paper
Additional Resources FundQuest White Paper (When Active Management Shines vs. Passive – June 2010)
See Post September 29, 2011: ALPHA vs. BETA (Round 2)
See Post April 1, 2010: Consistent Alpha
