Best of both worlds: Blending active and passive
31 July 2017 | Portfolio construction
Commentary by Ankul Daga, senior investment strategist with Vanguard Europe.
Discussing the merits of active and passive investing with financial advisers, I am often surprised to discover how many are blending active and passive funds in their portfolios.
Why the surprise? I think it is due to the polarising articles we see in the financial media. But I find very little of this polarisation in advisers' real-world decision-making. Advisers put tremendous thought into picking active funds and blending them with the market exposure they get through low-cost (and "boring") passive funds.
Advisers consider a range of criteria when selecting an actively managed fund. The fund manager's style, team, tenure and track record; the credibility of the fund house; the risk controls in place; and the access costs, just to name a few. It reflects real care to deliver value to the end client. Yet, still, many advisers tell me they still struggle to choose the "right" active managers. Over-analysis leads to paralysis.
These considerations are important, but in my view what most manager selection processes lack is a systematic and rigorous analytical framework. This is in distinct contrast to other portfolio construction decisions. Most advisers have a centralised investment process which systematically determines the asset allocation for investors based on their overall circumstances, attitude to risk and experience with investing. But often the active-passive decision is based more on intuition and past experience rather than explicit, forward-looking expectations.
Four key factors for success
In our view, in determining the mix of active and passive investments, there is a place for the same kind of robust, repeatable, defendable processes that would be used to construct other aspects of a client's portfolio. In new research, we explored a fund selection framework that can help advisers find the right balance between active and passive. In our view, the right combination depends on four key factors: alpha, cost, risk and patience. Let's look at them one by one.
Alpha. The most compelling reason to consider active investing is that it provides the possibility of outperformance, or alpha. A generalised hope of alpha is insufficient; however, advisers should establish a quantitative alpha expectation for the active funds they use.
Once an alpha expectation is established, the manager should be able to convincingly explain how – through their investment process, track record, and so on – he or she will meet this alpha expectation in the future. A realistic alpha expectation resulting from a clearly defined, rational investment process is the hallmark of a talented manager.
Cost. Once we find a talented fund manager, we need to factor in costs – that is, how much we are prepared to pay for their services. Our research shows that cost is the most important indicator of a manager's potential to outperform.
Active risk. In order to make an additional layer of return (alpha), the active manager needs to take active positions – that is, positions that are different from the market. This requires additional risk, or risk that's different from the market as a whole. This is what we call active risk. Some managers take more than others. Investors need to make a judgement on whether the active risk is sufficient to justify the alpha opportunity.
Active risk tolerance. The final factor our framework considers is patience, that is, does the client have the temperament to wait out shorter-to-medium-term losses in order eventually to access the alpha opportunity? We know that even talented active managers will inevitably have periods of underperformance, and some of these periods of underperformance can be quite long. Is the client prepared to stay invested during these periods?
Make the implicit explicit
We believe these are the four key ingredients to succeeding in building blended investment portfolios. Advisers need to pin their colors to the mast and make their implicit expectations explicit. Working through these factors in a systematic way will help advisers to show that their decisions are deliberate, rational and based on evidence. It is the basis of a process that is structured, repeatable and defendable.
The result is a process that can better educate clients about what a portfolio is trying to achieve, and what risks are involved. And a clear, agreed understanding of a portfolio's objectives and risks is often a key to stronger adviser-client relationships.
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Senior Investment Strategist
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