Author: Jason Liddle, Portfolio Manager
I always find it extremely valuable to hear the opinions and views from financial advisers as I travel around the country. The conversation is always direct and honest – something that I highly appreciate. It’s clear to me that their job is demanding and that there remains a wide variety of views on the subject of passive and active approaches to investing. Globally the debate has moved on from active versus passive to how these strategies can be combined to assist an investor in reaching their objectives. To fully examine this topic, it is necessary that financial advisers start challenging their previously held beliefs on passive investment strategies and why these may be more efficient vehicles over and above their most well-known feature of charging much lower fees.
While these products continue to provide one with exposure to the broad equity market, there are also smarter indexing options (“smart beta”) that can harvest a product focussing on specific equity risk characteristics like dividend yield, size, momentum or quality – these risk characteristics have shown a return premium above that of the broad market.
If your active equity manager provides a 20% return in a given calendar year be curious as to how much of that return was driven by the market and how much relates directly to a manager’s skill and value add. Let’s say the broad market has returned 15%. In the past the investment manager would reason to his or her client that the full investable set of stocks returned 15%, but I was able to deliver 20% so my alpha or skill over and above the index would be 5%. Academia and the industry has sharpened their pencil on this thing called alpha and what they found was that it consisted of a portfolio of stocks with a common risk character. An active investment manager’s process would systematically gravitate to portfolios with a certain risk character whether that be low price earnings (value) or higher return on equity (quality) or mid and small caps (size) as a result of their philosophy and how they filter, analyse and construct their portfolio. The passive industry is able to extract this formula and offer these products that provide a similar active experience.
Multi-asset class passive balanced funds provide further options if an investor is looking for measured exposure to all asset classes necessary for diversification. These products showcase the strong overwhelming influence of strategic asset allocation. Over the next few years passive product innovation is likely to be the rule and the end investor the ultimate beneficiary.
Most domestic active investment managers exhibit a valuation bias to varying degrees in their funds. Combining these managers then leads to a portfolio that has the self-same valuation bias. When the value style factor struggles, as is currently the case, the portfolio is affected in a uniform way with no offsetting influence. There are other complimentary product options available that can lead to improved diversification in one’s portfolios. For instance momentum and quality index products have shown to add unique and offsetting character to the value style. In many surveys and studies it is further proven that using these kinds of smart beta products perform more reliably and predictably relative to one another.
There is definitely skill out there among active managers but it is important to understand that skill is rare. In the plethora of products and investment managers out there be cautious about how you define and quantify skill and be curious about passive products that can provide both similar and unique experiences.
According to Morningstar, over the last 10 years up until July 2015, only 22% of active managers have beaten the ALSI and only 12% have beaten the SWIX. On balance, investing in the index has provided a superior outcome at much lesser fees. A 10 year period is a long period over which a skilful investment manager should be able to add value over and above a market related index. There are many market cycles that made up the last 10 year period; managers should mitigate the ‘harm’ in cycles that work against them and ‘capitalise’ during those cycles that work for them. Having exposure to the broad market is one example of managing risk when one is not convinced of the extent of skill out there while not compromising your overall investment strategy.
Lower fees is undoubtedly the feature one immediately thinks of when someone mentions the term passive. While these products present cheaper alternatives it is hoped that one first understands and is guided by whether this passive product will assist an investor in reaching their objective and adds to the overall investment strategy. Locally, the appreciation for the wider role that passive products can play will improve so be curious.
Jason Liddle is a Portfolio Manager at Satrix. He holds a Commerce degree from UCT, a Higher Certificate in Financial Markets and Instruments (cum laude) and is a Certified FRM (Financial Risk Manager) with the Global Association of Risk Professionals (GARP).