The Daily Telegraph - Saturday - Money
Faster, safer Portfolio tips that cut risk
Blending ‘active’ and ‘passive’ funds
Investors are moving away from costlier “actively managed” funds and instead pouring cash into “passive” funds, where stocks are chosen according to their position in an index, such as the FTSE All Share. TD Direct Investing, for instance, one of the largest fund brokers, reported the number of its customers buying passives had risen by 36pc in the past year.
Sales data from the Investment Association (IA), the trade body for asset managers, bears out the trend. The IA’s figures show the share of private investor money held in passive funds has almost doubled in a decade from 6.7pc in 2006 to 12pc in the second quarter of 2016.
This remains small compared to the proportion held in active funds, but the share is growing.
Passive funds, or “trackers”, are notably cheaper than their active counterparts and more investors are reasoning that this will give them a greater chance of success in the long term.
Supporters of both passive and active investing can produce reams of data to support their respective cases, but all agree that active funds start with a disadvantage thanks to their higher fees. Returns need to be higher simply to account for that.
An active fund may cost between 0.5pc and 1pc a year, while trackers can be bought for less than 0.1pc. There are then fees on top for platforms that are used to invest.
What’s more, many – some argue most – active funds do worse than the market anyway, meaning an investor has to get lucky with their choice of fund, adding greater uncertainty to their investing.
As such, more are settling for passives where they know they will not underperform the market.
Another large investing platform, Hargreaves Lansdown, has also witnessed the trend.
Laith Khalaf, senior analyst at the company, said: “Passive funds fit the bill for lots of different kinds of clients. Long-term buy-and-hold investors who don’t want to review their fund too often can use them to get basic exposure to the market.
“More sophisticated investors can use them tactically to get exposure to this and that market if they think it is set to rise.”
Best of both?
It need not be a case of either or. Mr Laith said that his company’s sales data did not show a clean split between passive devotees and active. Instead, he said: “We generally find that around nine in 10 passive investors use active funds too.”
Holding a mix means you have some assurance that, thanks to trackers, you will not trail the market badly. At the same time, you get to apply your own ideas in the hope of beating the crowd – the motivation of many an investor.
Michelle McGrade, chief investment officer of TD Direct Investing, said: “I would say that supplementing a range of low-cost passive funds with some active fund exposure is a sensible way to build a well-diversified portfolio suited to your needs and risk appetite.”
It makes sense to use passive funds in some markets more than others. Those that include large, wellresearched companies can be harder for active managers to do well in.
Mr Khalaf said: “The US market is typically the most popular market for investors to play purely passively. The gilt market is also a popular passive play, which makes sense as both of these markets have proved difficult for active managers.
“By contrast there are some markets where there is a wealth of talented managers who have been shown to add significant value over time, and where passive options are thin on the ground, in particular UK smaller companies and UK equity income.”
Funds to boost your passive picks
Investors can cut costs by selecting a core of passive funds that don’t need to change – UK investors are always likely to require a stake in the country’s largest companies housed in the FTSE 100, for example – but then add active funds operating in areas of the market that they believe will perform well in the nearer term. We asked fund analysts at researchers FE Analytics to crunch the numbers to identify those active funds that work well with commonly used tracker funds. They looked at technical measures to find the funds that helped to reduce risk and give a higher chance of gains, when blended with cheaper tracker funds in a 50/50 portfolio. Their focus was not simply to boost tracker performance with high-performing active funds but to look for active funds with a track record of selecting stocks that differ from those that dominate passive funds. In doing so, these portfolios should give a smoother ride.
FE Analytics focused on four technical measures: “volatility”, expressed as a percentage showing the margin by which a portfolio falls below or rises above its average return; “maximum drawdown”, which is the largest peak-to-trough fall an investor could have experienced in a five-year period; the risk adjusted return or “Sharpe ratio”, the return a portfolio delivers for the risk being taken compared to the market; and the “capture ratio”, how the portfolio performs relative to an index in rising and falling markets.
For investors holding a FTSE 100 tracker, FE Analytics identified the Neptune UK Mid Cap fund, managed by Mark Martin, as a good twin holding. Alex Paget, who conducted the research, said: “Though Martin is one of the more defensive managers out there, investors would have seen a better upside market capture, albeit by a very small margin, by blending the two strategies.
“The most significant change, though, is with downside capture ratio. While investors in a FTSE 100 tracker would have seen their holding move in line with the index, by adding Neptune UK Mid Cap, they would have only ‘captured’ 63.24pc of market falls.”
For those investing in a FTSE 250 tracker, Mr Paget selected Trojan Income, managed by Francis Brooke of Troy Asset Management. The portfolio holds a stable of the country’s largest companies.
He said: “Though a traditional FTSE 250 investor would have had to accept a lower total return over five years, by blending their tracker with Trojan Income, those losses would have been reduced.
“The blend would have lowered an investor’s overall volatility, but increased their risk-adjusted returns relative to the FTSE.
“While investors would have had to give up 1.5pc of potential market upside by adding Trojan Income to the mix, Brooke’s defensive strategy would have meant investors would have captured 25pc less of market downside.”
‘Twin passive funds with active holdings that will do well in the shorter term’