The debate over whether active is better than passive investing is an old one, with views firmly embedded on both sides. Passive investing has dominated fund inflows in recent years. In January 2020, the value of money invested in index funds globally passed $10tn, while in the US (where passive investment has been particularly popular with retail investors), assets under management in passive funds overtook AUM for actively managed mutual funds in 2019.
Their lower cost and the variable ability of actively managed funds to outperform make it easy to see the attractions of passive funds – particularly in a rising market such as we have seen in the last decade. However, the argument in favour of passive investment is not open and shut. Passive funds are not without flaws and constructing an investment strategy based purely on index-tracking funds bakes these flaws into long-term investment performance.
Diversification is key
A large part of the investment process at FE Investments is aimed at maintaining the returns in a given portfolio but reducing the level of risk taken. We call this maximising market participation.
Source: FE Investments, 2019
Diversification ratios are important as they indicate the amount of unwarranted risk that we have diversified away. Why take risk that you do not need? It is a simple concept and one we think all DFMs should use.
Aside from the initial decision of which index to track, passive funds, by design, make no investment judgements or decisions and this has an effect on diversification. You can achieve diversification across geographical regions as well as asset classes using passive funds, but it becomes harder to maximise diversification within regions or asset classes by just using index-trackers. The chart below shows the difference in diversification for three portfolios we ran through our portfolio optimiser to maximise diversification.
Source: FE Investments, 2019
As the chart shows, our Hybrid portfolios (a blend of active and passive funds) have significantly greater diversification than a portfolio constructed using just passive funds.* The chart clearly demonstrates that combining a range of active and passive investments strategies improves diversification and drives the diversification ratio upward.
Passive funds follow the market, wherever it goes
Passive funds have the advantage of lowering costs but are not without specific investment risks that need to be managed. One issue is concentration risk - tracking the FTSE 100 instead of the FTSE 350 automatically rules out 250 potential stocks – as well as increasing systemic risk by investing according to market weight. Just 14 companies in the FTSE All Share, 1.2 per cent of the index, account for 40 per cent of the total value of the index. Despite this we feel comfortable using their low-cost structure and their factor exposures to diversify the portfolio. We see them as momentum trades in both bull and bear markets, so we leverage this to our advantage. The strong run in markets prior to, and including the Global Finical Crisis, is an excellent example.
But momentum also carries risk. The change in valuations to banks following the crisis was stark. For example, Royal Bank of Scotland’s valuation fell from $120bn to $4.6bn, a fall of 96 per cent, between 2007 and 2009. These are the risks that we are keen to avoid in our stress testing within our portfolios. Including active funds in a portfolio helps reduce factor risk exposure.
Concentration risk in 2020
Momentum and concentration risk are not just to be found in the historic data. FAANGs and broad technology related stocks now contribute to a significant element of the S&P 500 and this has been a strong momentum trade for many years. Whilst we appreciate that the run could continue, the rise in markets since the financial crisis is one of the longest on record. Statistically, as time passes the probability of a sharp setback increases and as proponents of risk management and diversification, we aim to balance the risk in client portfolios. The US remains the equity market most likely to outperform over the medium-term, however, the market volatility surrounding the US election shows tech stocks remain vulnerable to a change in sentiment. Getting long-term exposure to the US market while balancing the risk of overexposure to specific sectors and retaining exposure to out-of-favour sectors needs more than a simple passive investment strategy to maximise diversification and minimise momentum and concentration risk.
We are therefore sceptical about the long-term benefits of a purely passive asset allocation and of passive underlying index funds. Risks exist within purely passive funds, this can be sector, currency or due to other risk factor exposures. Diversification can be managed by using institutional class portfolio optimisation, while the active rebalancing of asset allocation is essential to reap the benefits of cheap valuations and to diversify a portfolio. We believe that by managing risk carefully the returns follow suit. Ultimately, we aim to mitigate undue surprises, keep clients invested and retain your clients over the market cycle. Passive funds have a role to play but they are far from the complete solution.
FE Investments
Since launching our Discretionary Managed Portfolios in 2015, we have become a multi-award-winning Discretionary Fund Manager and been named as one of the fastest growing DFMs on platform, with more than £3bn of assets under management.
Our Hybrid Portfolio range combines passive and active fund managers, balancing cost benefits with our track record of selecting active fund managers that complement each other to maximise portfolio diversification.
Learn more about our Managed Portfolio Service.
If you’d like to learn more about FE Investments and our award-winning Manged Portfolio Service, please get in touch with one of our experts to arrange a web demonstration.
*As we do not run passive portfolios we used a mix of passive indices to model performance of a portfolio constructed using passive funds.
The price and value of investments and their income fluctuates. You may get back less than you originally invested.
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