Active vs Passive? Or, Passive & Active.

12th August 2010

There has been a lot of debate about whether passive fund management or active fund management is better. Active funds in particular have come in for flack for charging too much. But this debate is starting to look unsophisticated. Should investors instead be asking themselves how both strategies can fit into a portfolio?

The Daily Telegraph giving the subject a lot of attention recently with Paul Farrow firmly rebutting claims by one fund manager that – like Stella Artois – his funds are reassuringly expensive.

To set the argument in context, passive management is generally about tracking an index- the most obvious being the FTSE 100 – but passive funds now track all manner of other investments from baskets of commodities to currencies. With active management, managers try and spot winners among groups of shares and other securities like bonds, with the investment universe partly determined by the fund's sector but also by the fund's own investment aims and strategy.

Active management is accepted as the more expensive of the two techniques because it requires a skilled fund manager at the helm, though charges vary between funds in different categories. Investing in emerging markets, for example, is generally more expensive than investing in developed markets. Investing in equities is more expensive than investing in bonds.

The debate as to which is better has historically been polarized, but increasingly there is a realisation that a third way may deliver the best value. This suggests that rather than it being a case of passive versus active it should be a case of passive and active.

Blending active and passive strategies is already widely done in the institutional market and HSBC – which has both types of fund – suggests that the debate is entering a second phase where the discussion focuses on how much of a portfolio each should represent.

HSBC head of external distribution Phil Reid says: "This is the second phase of the debate. I think most people agree that both active and passive have their place. What controls how you apply passive and active is really the client's risk ‘budget'. By that I mean things like size of portfolio and what they are genuinely looking to achieve. If you are client who has got a hundred thousand pounds would you want to be choosing direct commodities around the edges of your portfolio? Maybe not. We provide a suite of products that can be used by clients. What any IFA should ask during their due diligence is how the tools they have in their bag are deployed."

"There will be an increasing momentum behind passive, but there will not be an overnight change."

This argument has found some resonance in the IFA market. IFA Martin Bamford makes the case for the use of both passive and active funds and warns against solely focusing on cost:

Here is TCF Investment's David Norman on financial blog the Money Debate . pointing out that the debate should not be between active and passive on the basis that one is cheap and the other is expensive, but about clarity for the end investor.

Mr. Bamford believes that an efficient ‘core' should be passive with active management potentially adding value in less efficient markets, for example where company research or economic indicators are less reliable which may suit the stock picking manager better.

Others have argued that a fund's core should be active, using passive funds for shorter-term asset allocation strategies. For an example of how the strategy is used in practice , take a look at recently portfolio activity from Henderson's multi-manager head Mark Harris: 

However they are blended, active and passive have a place in portfolio. Neither is necessarily better than the other and it is time for the debate to move on from the bald premise that ‘cheap is good'. Investors should be asking themselves the best place for each strategy within a portfolio.  

 

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