Andrew Pitt: An active approach to passives

22 Jun 2020 Expert insight

Andrew Pitt, head of charities at Rathbones, looks at the advantages of building a portfolio that blends both active and passive vehicles.

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With so much uncertainty in markets, charity investors may be reassessing their investment strategies. The popularity of passive funds has risen dramatically over the past few years and when used with active funds in the same portfolio, these two opposites can work well together.  

It’s not uncommon for an investment strategy to be followed to such an extent that it becomes almost tribal. Dedicated followers of either value or growth investing are one example. Another is the active versus passive camps, where fans of index funds argue about the virtues of simple, low-cost investing which, after fees, has outperformed many active managers. 

Unlike value and growth-focused investing, which should provide contrasting exposures if executed correctly, multi-asset portfolios can benefit from holding a blend of active and passive funds. The advantages of both approaches are nuanced and the choice depends on the opportunity the market presents.

Passive funds have advantages. The biggest and almost indisputable benefit is lower cost. For instance, a FTSE 100 exchange traded fund (ETF) can cost as little as 0.05 to 0.06 of a percentage point, while some S&P 500 ETFs are even free. They provide cheap and efficient exposure to a stock market index (also called equity beta).

Through an ETF it’s also possible to gain exposure to asset classes that are difficult to buy directly but have strong portfolio-diversifying qualities. Physically backed gold ETFs are a great example of an asset that has added a diversified source of returns to portfolios in 2020.

Far from infallible

However, when markets are particularly volatile and less liquid, ETFs can be far from infallible. Understanding these shortfalls is crucial, and can not only give active managers an edge, but also help investors make better decisions.

This situation has been more evident in 2020 with corporate bond ETFs. With more sellers than buyers during the stomach-churning falls triggered by Covid-19, and the underlying market liquidity drying up quickly, some ETFs not only fell in value, but at a quicker rate than the indices they are following.

By taking into consideration various factors such as a bond’s liquidity (how big the pool of buyers and sellers is), duration (a bond or portfolio’s sensitivity to changes in interest rates), the underlying financial health of the issuers and portfolio cash management, active managers can have an advantage over ETFs. Lower costs are important but could prove poor value for money if an ETF is structurally flawed or blindsided by one or more of these factors.

Under greater scrutiny

As for their equity counterparts, there are other issues to consider beyond beating an index. An income fund generally targets a yield that is greater than the market or can grow its dividend at a greater rate. Some active managers are trying to ensure a return with a greater degree of capital preservation in down markets.

With more scrutiny on qualitative attributes such as governance and environmental considerations, these can also be factored into an active strategy. Since the start of 2020, many UK equity funds, whether open-ended or investment trusts, large or small-cap focused, income or total-return orientated, have performed well through the extraordinary turbulence on a relative and risk-adjusted basis.

The decision to allocate to various asset classes depends on your financial objectives and goals. However, there are many advantages to building a portfolio that blends both active and passive vehicles rather than sticking with one or the other. Understanding the trade-offs between costs, asset exposure and flexibility of execution by active and passive providers can help charity investors reach their desired outcome.

Andrew Pitt is head of charities, London, at Rathbone Investment Management, and there is more information to help charities navigate the Covid-19 crisis on the Rathones website.

 

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