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Active or passive? You’re asking the wrong question!
The merits of active funds over passives generate lots of column inches, but there are more important investment decisions to make.
by Mike Deverell on Nov 19, 2015 at 08:00Follow @equilibriumam
'Should I invest in active or passive funds?'
This is a question that generates plenty of column inches, but frankly I think it’s the wrong question to be asking! Or at least, when constructing a portfolio it is way down the list of things to consider.
There are a number of steps to go through first before you get to the question of what to buy:
- What am I trying to achieve? What’s my money for and when do I need it?
- What return do I need in order to achieve my goals?
- How much risk do I need to take to get there?
- How much risk am I willing to take?
- How much can I afford to lose?
Some of your answers might conflict with others. In order to achieve your desired outcome you might need to take more risk than you are willing or can afford to take. That might require compromise.
This is essentially a financial planning exercise. Only once you know the answer to those questions can you then move onto the actual investment and select an asset allocation which best meets your needs.
Deciding your asset allocation is the most important investment decision you will make. How much money you invest in equities, for example, makes much more of a difference compared to which fund or which stocks you buy. How this is balanced by cash, bonds, property or alternatives to provide diversification is vital.
Having made that decision, you might think now is the time to decide whether to go active or passive. Not so fast!
An important but underrated step is to consider what fund style or behaviour you require. Funds are the building blocks of your portfolio and what matters most is how well each one fits in with your overall plan.
The most obvious part of this exercise is deciding whether the fund needs to invest primarily for growth or income, but it is more than that. For example, if we are looking at UK equities do you want a fund that is more defensive and will fall less when the market drops, or more aggressive and more likely to outperform when it goes up?
You need to consider how well each fund complements other holdings in your portfolio. There’s little point having two funds doing the same thing. You want funds which will perform well at different times.
What drives fund performance?
There are a number of known factors which might explain why a fund does well or badly.
Nobel laureate Eugene Fama and Kenneth French showed that, over the long term, small caps tend to beat large caps whilst value stocks also tend to outperform. Fama and French defined value stocks as those with low price-to-book ratios; a low market value relative to the value of net assets shown in the company accounts.
You can enhance your chance of long term outperformance by tilting your portfolio towards small and value stocks. These are generally riskier than the market. Smaller companies have a greater chance of failure than large ones and value stocks are usually cheap for a reason, such as perceived poor prospects. A small cap or value fund will not necessarily be more volatile than the market but this doesn’t mean those risks are not real.
Other scholars have mooted a fourth factor; momentum. Stocks tend to overshoot fair value both on the way up or the way down. This is where the 'run your winners' argument comes from.
So if those factors can help performance, what can hurt it? The principle one is cost, whether that is management fees or trading costs. A fund with a high turnover will have high trading costs which won’t show up in the fund’s ongoing charges figure (OCF), only in performance.
Finally, only a fund with a reasonably high 'active share' will have a chance of beating an index. A fund with an active share of 15% is essentially 85% the same as the index. Any outperformance will probably be swallowed by charges.
In summary, a good fund needs a strong process and usually at least two of the following style factors:
- a tilt towards smaller companies;
- a disciplined, value approach or
- a 'run your winners' approach;
- low management fees;
- low turnover;
- a high active share.
- Miton buys 'undervalued' assets and sell them when they hit a target price.
- The Miton fund invests a substantial proportion in smaller companies.
- Lindsell Train holds strong, high quality companies and runs its winners.
- The turnover of stocks within the Lindsell Train fund is very low.
- Both funds have a high active share.
These funds tend to perform at different times making them a good potential combination. They are both tilted towards a number of the known factors which influence performance. Whether or not their strong past performance is down to manager skill or simply because of these style factors is irrelevant. They provided the behaviour I was looking for when we bought them.
There are some passive funds which have style tilts but we have been disappointed in their performance, despite their low cost.
Unfortunately, the difficulty for a private investor without the sort of access to fund managers we enjoy, is identifying the above factors in a fund. I would therefore reiterate the point I made at the beginning.
If asset allocation accounts for around 90% of the variance of your portfolio returns and things like fund selection account for 10%, on which part of the investment piece should you spend most of your time?
Concentrate on getting your asset allocation right, making sure it matches your objectives and risk profile. If you have the time and inclination to look for active managers then make sure you bear in mind the factors which might help.
Mike Deverell is a partner at Equilibrium Asset Management in Cheshire. The views expressed in this article are his and do not constitute investment advice.
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