Four factors can help to create a structured, repeatable, defendable process for robust blending of active and passive strategies
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 portfolio.
Why the surprise? I think it is due to the polarising articles we see in 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, boring passive funds.
Advisers consider a range of criteria when selecting an actively managed fund. The fund manager’s style; team; tenure; 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 struggle to choose the “right” active managers. Over analysing 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, future expectations.
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 of 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 – they 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 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 fund 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 to the market. This requires additional risk, or risk that’s different to the market as a whole, and it’s this that we call active risk. Some managers take more active risk than others. Investors need to make a judgment on whether the active risk is sufficient to justify the alpha opportunity.
