Investors feeling a little torn
ONE OF the longestrunning debates in the investment world is whether an active or passive strategy achieves superior returns for investors over the long term. Active fund managers aim to outperform a specific benchmark, such as the FTSE 100 index, by actively buying stocks or assets they believe to be undervalued and likely to perform well. This is based on the theory that asset prices can deviate from their true value for various reasons, such as momentum, herding or overreaction to a specific event.
Passive investment involves purchasing the constituents of an index in the same weighting as they appear in the index and can involve either tracker funds or exchange traded funds. The aim is to replicate the performance of the index as closely as possible and is based on the investment philosophy of the “efficient market hypothesis”, which states that an asset’s price fully reflects all available information. According to this theory, it seems impossible to consistently “beat the market” on a risk-adjusted basis.
At NLP, we believe in discretionary investment management, using any fund deemed appropriate and considering the merits of active or passive funds to play out our themes.
The lower cost of passive management has led many to suggest this is the most effective way to invest. This is often supported by the supposition that few active managers consistently outperform the index. We take a more pragmatic view. Passive investment has a place in portfolios and can often be an inexpensive way to get certain exposures. However, 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 it guarantees underperformance relative to the index once fees are taken into account. By finding managers who regularly outperform their benchmark, considerable outperformance can be achieved.
Another benefit of active management is seen in less-efficient sectors, such as small caps and emerging markets. Small caps tend not to receive the in-depth research afforded to larger companies and value can be uncovered by the canny researcher. Emerging markets encompass a range of countries and it is dangerous to class them as homogenous. An active manager can allocate to preferred countries. Avoiding being in the wrong asset at the wrong time can be as important to returns as holding a winner.
Passive management is useful for exposure to US large cap equities (a well-researched and efficient market, where active managers struggle to consistently add value) and for exposure to other areas if appropriate.
Fees are important but investors should focus on net returns (after all fees and charges). A track record of strong risk-adjusted returns may justify the extra costs for active management. With stock markets currently high, stock selection is ever more important. And rememember, past performance should not be seen as an indication of future performance. The value of investments and income from them may go down as well as up and investors may not get back the amount they invested. Movement in exchange rates may also cause investments to go up or down.
Elliot Gothold is a consultant with NLP Financial Management, 020 7472-5543, elliot.gothold@nlpfm.co.uk