Investment Strategies

Active Vs Passive Investing - The Debate Rolls On

Emma Rees WealthBriefing Features Editor March 11, 2010

Active Vs Passive Investing - The Debate Rolls On

Ultimately, the debate on whether passive investing makes better value for money over the long term than active investing is, perhaps, one of those investment issues that will never be entirely resolved one way or the other. But there is no doubt that with ETFs now such a visible part of the investment landscape, the passive approach is getting a lot of attention.

Increasingly there is a move by portfolio managers towards using passive investment vehicles to meet investment objectives in clients’ portfolios.

HSBC Private Bank, for example, recently launched a discretionary portfolio service for clients based on exchange traded funds late in 2009. Fund manager T Bailey is offering a low cost multi-asset class fund that gains exposure to equities, bonds and commodities purely via ETFs and other index trackers.

Wealth managers have embraced ETFs, particularly over the last 18 months, as private clients have been demanding simple, inexpensive, liquid and transparent ways of expressing both their strategic asset allocation and thematic tactical calls, said Claire Perryman, vice president of iShares, the ETF arm of Barclays Global Investors.  

“At the same time, ETF providers have launched an increasing number of funds across a range of asset classes giving investors significantly more choice. This has led to many wealth managers developing portfolios or funds, where in-house asset allocation decisions are implemented using solely or predominantly via ETFs,” she said.

ETFs, which now cover asset classes ranging from major stock indices to commodities, infrastructure, hedge funds and private equity, have boomed in recent years. Traded and listed like individual stocks, ETFs typically carry a total expense ratio – comprising various costs – considerably lower than a conventional mutual fund.

This growing in popularity of ETFs has also been reflected by self-directed investors. Barclays Stockbrokers saw assets invested in ETFs increasing 115 per cent in 2009 compared to a growth in managed funds of approximately 50 per cent over the same period. 

Over the last decade, passive investing has become a conscious investment decision within private client portfolios, as the range of options has increased markedly, starting with tracker funds in the 1990s and more recently ETFs and some structured products.

“It no longer merely represents core index investing but enables the investor to have exposure to sectors or asset classes they might not otherwise have sufficient funds with which to do so,” according to Victoria Hoskins from Barclays Wealth.

Passive benefits

There are undoubted benefits to using passive vehicles, such as cost, accessibility and liquidity. For example, the low cost of the T Bailey fund with a total expense ratio of 0.99 per cent compared to 2 and 2.5 per cent a year for similar funds that use actively-managed funds is typical. The simplicity of ETFs has also proved to be enticing, enabling efficient implementation of cross asset class, sector, geographic and thematic views.

Tom Becket, chief investment officer at Psigma Investment Management, believes that the increasing use of passive vehicles is due to active managers continuing to disappoint. “Last year, many failed to pick up on the upside and the year before they very often failed to protect investments with assets falling by more than markets.”

Wealth managers tend to use ETFs in two ways, either as a quick way of gaining tactical exposure to a market with an immediacy which is not possible through active funds.

“They are also a cheap way to gain exposure to areas where it is difficult to add alpha, such as investing in the S&P 500,” said Sanna-Liisa Valtanen, director, Asset Risk Consultants.

According to ARC, empirical evidence over the last 30 years demonstrates that the majority of added value is driven by asset allocation decisions rather than choosing one stock over another. “There are therefore an increasing number of strategies offered that concentrate on making the tactical asset allocation decisions and are populated by ETFs,” said Ms Valtanen.

Passive drawbacks

However, investment experts argue that passive vehicles are not a panacea and should be used selectively. One particular concern is that as markets are most likely to level out in 2010, now may not be the time to simply gain cheap exposure to the market or ‘beta’ and may instead be just the time to focus on raising the probability of success - or alpha - by using active funds.

“No one cares about high fees when markets are rising, but I question whether this renewed interest in ETFs has come at the wrong time as this is not the time to hold beta,” said Mr Becket. Like many investment experts, he believes that markets will track sideways this year and with market dispersion and disparity likely, picking the right stocks will become key. “Now is not the time to be reconsidering a passive stance,” he said.

However, when markets are clearly directional, active management may not add the value required to justify the fees associated with it.

“Client portfolios could get comparable and possibly less volatile returns on a cost adjusted basis from passive vehicles particularly in efficient well diversified markets,” according to Ms Hoskins from Barclays Wealth. Conversely, during times of volatility and uncertainty, or in less efficient markets, particularly where indices are dominated by a small number of companies or sectors, an active approach can add significant performance enhancement to the private client portfolio.

“Investment managers are increasingly using the flexibility of switching between management styles in an attempt to take advantage of market conditions. We need to ensure that managers of private client portfolios retain the ability to make such judgement calls to ensure that the returns achieved reflect the cost associated with running the portfolio,” said Ms Hoskins.

Flat market uses

That does not mean that ETFs, or passive vehicles do not have their uses in a flat market. ETFs and active funds tend to be viewed as complementary, and the decision around which works best in a particular scenario is driven by the type of exposure that a wealth manager is seeking.

“ETFs offer a very precise and quick way of expressing an investment theme, without an inherent style or sector bias, with low management fees and without the risk of significant tracking error,” said Ms Perryman. However, she acknowledges that there may be times where a wealth manager prefers to delegate such decisions to an active fund manager, and this may because of market conditions or in the belief that an active manager can outperform. “In the end, it is really about what the wealth manager is trying to achieve in a broader portfolio context. In reality, ETFs often sit alongside active funds in private client portfolios, performing different roles” she said.

Barclays Wealth uses passive vehicles for short term tactical plays as they allow a low cost entry point that may also be exited quickly and efficiently without distorting the long term strategy within the portfolio. Psigma adopts a similar approach.

“We use passive vehicles for market timing with up to 10 per cent of our fund of funds invested in FTSE 100 ETFs so we can get money in and out of the market easily. It is much easier to do this as ETFs have an immediacy that is not available with active funds, which might only be priced once a day,” said PSigma’s Mr Becket.

Mr Becket also points out that some assets, like agriculture, are really only available via vehicles such as ETFs. Over time, ETFs are focusing on smaller niches of the investment universe and continually becoming more specific, often bridging the gap between actively managed and passively managed strategies.

According to Ms Hopkins, passive vehicles tend to work best in efficient markets for example, the S&P 500 and indeed the FTSE 100 where the premise of core exposure to a particular market is recommended and the returns from active management after charges do not present significant outperformance.

PSigma estimates that overall some 5-10 per cent of its clients’ portfolios are invested via passive vehicles like ETFs.  “We have some discretionary portfolios where everything is invested in ETFs and one advantage is, of course, that the TER is much lower. But overall, the active managers we choose do add value and we believe that they will do much better this year,” said Mr Becket. “Of course, there are those clients that believe that asset allocation is key, in which case passive vehicles work well.”

In Barclays’ case, there is no fixed proportion of active versus passive vehicles in client portfolios as it is based on every individual client's belief in manager skill which is a question it asks of all clients.  

Regulatory impact

There is speculation as to whether initiatives like the Retail Distribution Review (RDR) in the UK and a general move towards a fee based approach globally is likely to support the further use of passive vehicles in private client portfolios in future. (The RDR is a UK regulatory programme of reform designed to raise the quality of financial advice).

 FSA consultation papers on the RDR clearly state that ETFs should be considered when deciding which products are suitable for a retail client. “As a result, wealth managers have already been actively considering how ETFs will fit into their overall proposition,” said iShares’ Ms Perryman.

“Furthermore, ETFs clearly lend themselves well to a fee based model, as they do not typically offer retrocessions. Consequently, we fully expect the use of ETFs to increase significantly,” she said.

Ms Valtanen from ARC believes that the impact will be greater at a retail IFA level where there will be two approaches. Advisors will either undertake strategic asset allocation themselves by creating investment committees, but are unlikely to carry out fund selection themselves, instead populating client portfolios using ETFs. On the other hand, she said, “they [advisors] may conduct client risk profiles themselves and outsource everything else to discretionary investment managers. “It is early days, but the latter is likely to be more popular.”

Barclays Wealth, however, does not believe that a fee based approach would necessarily in itself lead to an increased use of passive vehicles.

“A fee based approach should ensure that the client's interests and the business interests are one, in other words the better the long term performance of the portfolio, the higher the fee. Should a higher return be achieved by passive as oppposed to active vehicles then that would be the correct decision to make for the client,”  concluded Ms Hoskins.

Ultimately, the debate on whether passive investing makes better value for money over the long term than active investing is, perhaps, one of those investment issues that will never be entirely resolved one way or the other. But there is no doubt that with ETFs now such a visible part of the investment landscape, the passive approach is getting a lot of attention.

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