Investments: the active ingredient
WH E N WE m a n a g e i n v e s t - ment portfolios for our clients, we are relatively unrestricted in what funds we can use and so are free to access anything we feel appropriate. This means we have to consider the merits of using active or passive funds.
Passive investment can involve buying all the constituents of an index so as to replicate the performance of that index. Active investment involves managers actively selecting their favourite stocks or assets.
As passive management involves little skill, it can be done cheaply. This has led to many suggesting that this is the most effective way to invest money. This argument is often supported by the supposition that few active managers consistently outperform the index. We take a more pragmatic view. We do believe passive investment has a place in portfolios and can often be an inexpensive way to get exposure to certain markets. However we are firm believers that you do not want passive investment in all markets.
There are some excellent active managers who consistently beat their benchmark. One problem with passive investment is that it guarantees underperformance relative to the index, once fees are taken into account. By finding managers who regularly outperform the index, even by one to two per cent annually, considerable outperformance can result.
When volatility in markets increases, there can be marked swings in the price of shares on a daily basis. These large moves in stocks on a short-term basis are where active managers can score well.
Good-quality companies often see their shares fall with the overall market, despite nothing changing in the outlook for their business. As fear grips the market and shares are sold indiscriminately, this can create excellent entry points for those prepared to look through the “short-term noise” and buy for the longer term.
Another benefit of active management can be seen in less efficient markets. Smaller companies and emerging markets are not areas where we would use passive funds. Emerging markets encompass a wide range of countries and it is dangerous to class emerging markets as a homogeneous region. An active manager can allocate to preferred countries while ignoring those deemed more challenged. Avoiding being in the wrong asset at the wrong time can be as important to returns as holding a winner. Last year was a great example; active managers could significantly outperform simply by avoiding banks, oil and mining stocks, something trackers cannot do.
Smaller companies and emerging markets tend not to receive the indepth research and scrutiny afforded to larger companies and hence value can be uncovered by the canny and inquisitive researcher. This is why we use passive management in America, which is an extremely well analysed and efficient market where active managers can often struggle to add value.
We are prepared to combine both passive and active investments where we feel it is appropriate but have faith in our ability to find managers who can regularly outperform their benchmark and believe we are entering an environment where stock selection is becoming ever more important.
Remember past performance should not be seen as an indication of future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amount they originally invested. Changes in exchange rates may also cause the value of investments to go up or down. Adam Katten is managing director of NLP Financial Management, 020 7472 5550, adam.katten@nlpfm.co.uk