The benefits of Passive investing |
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Simple to implement |
The asset allocation is the biggest determinant of investment returns—more than the potential outperformance the active funds can deliver. Within regions there is a wide breadth of indices. The Investment Strategy team take a view on which indices to track based on their view of a region. We can easily target the specific indices by Investing passively. |
Limited risk of underperformance |
We use passive managers with expertise in tracking indices. The risk passive funds will underperform the market indices is low. |
Cheaper fund cost |
The average cost of our passive funds is 0.16% compared to 0.75% for our active funds. One of the factors we consider within the fund diligence process is the potential to deliver outperformance after this additional cost. There are times where the probability is low and we prefer to hold the cheaper passive strategy. |
Quicker due diligence |
The M&G Treasury and Investment Office manages the fund research process. It requires a large team with plenty of expertise to research new active funds and to monitor the existing funds. Less oversight is needed for passive strategies. |
Diversification
Best of both: blending active and passive funds
5 Jul 24 10 min read
When it comes to active and passive strategies in portfolios, the debate is often framed in the context of which is better than the other. In our view, the question isn’t active or passive but when to use each. We blend active and passive strategies in our Hybrid portfolios. One of the key portfolio construction decisions we make is when to harness the benefits of lower costs and when to seek outperformance.
In this article we look at how we combine both, the pros and cons for active and passive strategies and key factors we consider when we decide to use an active fund or a passive fund for different components of the portfolios.
Here’s how we define active and passive:
- Active strategies pick and choose which investments to hold using in depth research with the aim of trying to deliver returns higher than their stated benchmark
- Passive strategies simply seek to track the performance of their benchmark by replicating the same or similar holdings of a benchmark.
A portfolio of building blocks
Our portfolios are constructed as a series of building blocks. We consider each asset-class separately and blend different funds together to create a robust portfolio. One of the reasons we do this is to manage investment styles such as value and growth and it also gives us different ‘levers’ to pull within asset classes to express a view. One of these levers is whether to use more active or passive depending on the market circumstances.
The benefits of Active investing |
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The opportunity for outperformance |
The passive funds in the models will only deliver the return of the broad market minus costs whereas the active funds offer the opportunity to gain additional returns through investing or not investing in certain stocks and bonds. |
Managing risk |
Active managers can reduce potential losses in the market by avoiding certain companies or sectors or regions. For example a passive bond fund has to hold the index even if lower quality issuers of debt are at risk of defaulting whereas an active manager can choose not to hold these bonds. |
Investment Flexibility |
Active funds are not completely tied to an index and have more flexibility. Our allocation to emerging market bonds for example combines different bond indices which, for an active fund, is easier to do meaning we can better shape which emerging market bond indices we want exposure to in the models. |
Access to more asset-classes |
For certain asset-classes such as India equities and absolute return we think the only solution is active management due to the risks with investing passively. Therefore active management does give us the option to access more of our preferred asset-classes. |
When we use passive and when we use active
Each asset class has different investment drivers. Using the building blocks approach to our asset-classes means we can easily alter our preferred exposures.
It is harder for active managers to outperform in developed equity markets such as the UK, US, Europe and Japan. For example, in 2023 less than 1 in 3 Europe equity active funds beat their index1. We think having a significant allocation to passive strategies in Europe equities makes sense and we use active funds to tilt the portfolio towards the styles that we prefer based on views.
In the US we think the scope to outperform the S&P 500 Index is limited. We’re wary of US equity funds either taking positions very similar to the index in order to limit the risk of underperformance or we see strategies straying significantly from their underlying benchmark in order to generate outperformance, thereby potentially increasing their risk profile. We prefer to invest in passive US equity funds.
Within emerging market equities we think the opportunity to outperform is significant with more inefficient capital allocation and significant performance dispersion. For example the average annual return dispersion between the best and world performing countries over the last 10 years is 50%2 which means by taking a view within the index there is the opportunity to deliver outperformance. For Indian equities we only allocate via an active manager. In this market, some shares have high valuations and there are governance risks in the market. We think the value of active management here is crucial.
When investing in corporate bonds and emerging market bonds, where possible, we try to use active funds. Bond indices are weighted according to the debt outstanding for each company or country which means the most indebted borrowers have the largest weight in the index. Active bond managers have the option to avoid companies that have high leverage whereas a passive fund will often have to increase their exposure as companies’ debt levels rise. This matters the most for high yield and emerging market bonds; we think it's particularly important to utilise active management in those areas because the credit quality of issuers varies significantly.
Government bonds do not experience this issue; we decide how much to hold in government bonds in our asset allocation and then use passive funds to get exposure to UK and US government bonds.
In summary
The question for us isn’t active or passive but when we utilise each and by how much. The consideration we’re making is based on the opportunity we see for active managers to outperform and when we want to use active management to express our views within an asset-class. The building blocks approach we use allows us to draw upon these different levers within each of the markets in the portfolios.
1Source Morningstar European Active-Passive barometer 2023
2Source: BlackRock iShares, data to 29/12/2023
Past performance is not a reliable indicator of future performance. The value of an investment can go down as well as up and your client may get back less than they’ve paid in.