We all have different aspirations in life, so we believe that tailor-made investment portfolios should be at the heart of first-class wealth management.
As far as successful investing is concerned, you can’t just jump on the gravy train. Although passive versus active investing is often presented as a simple binary choice, the reality is that your investment needs will not be fulfilled by opting for one or the other.
It is important to understand the pros and cons of both passive and active investing and to consider why, in spite of the growing popularity of passive products, active investments should always feature in your portfolio.
Passive providers are liable to quote the statistic that more than 50% of active managers underperform the benchmark. They might omit to mention, however, that all passive products underperform the same benchmark by at least their cost, meaning that whilst some active managers underperform, all passive managers do.
It could be argued that there are no unknowns regarding passive managers’ underperformance, whereas active managers’ performance can be unpredictable. Yet it should be remembered that active managers can also outperform the benchmark. Another issue with the statistics is that poor managers tend to fail but their poor results live on in studies, so it would be more appropriate to look at the percentage of active managers who currently remain in business that outperform passive products on an after-cost basis.
The cost characteristics of passive products are undoubtedly attractive, and they should be used in asset classes where they can be prudently applied, such as in core holdings of equities. An active product is far superior, however, in asset classes such as fixed income, foreign exchange and physical commodities.
Furthermore, the longer the investment horizon, the more likely it is that an active manager would outperform their passive counterpart, making an absolute ‘saving’ assumption more difficult to determine.
Whilst the costs of an investment are an important consideration and passive investing is cheaper than active investing it flies in the face of years of investment wisdom to make cost your only investment criteria.
There are many other examples of how passive investing contradicts investment wisdom. Although the first rule of investment is “don’t lose money”, passive solutions only follow the direction of markets, both up and down. According to respected mutual fund manager John Templeton, the four most dangerous words in investing are “this time it’s different”, yet passive solutions buy most of whatever is currently in favour. Moreover, passive solutions ignore valuation, instead only acknowledging price, potentially missing out on mis-valued opportunities. When considering risk versus reward, what is comfortable is rarely profitable when it comes to investing, but there is no choice in passive investing. Passive investing also disregards the advice to “know what you own”, since knowing or understanding what you own and why is irrelevant in passive products. Finally, although investment wisdom tells us not to over-diversify, passive solutions could not be more diversified, as they represent the entire market.
There are a number of other factors that are crucial to an overall investment solution, and which passive providers are unlikely to highlight. These include:
- PHILOSOPHY: Passive investment holdings tend to be weighted according to the market capitalisation of each company. This means that passive investors often end up buying the most expensive shares, because there is no investment philosophy motivating investment decisions. This could have a negative impact on investors’ long-term results.
- RISK MANAGEMENT: Passive products do not offer risk management, whilst active managers can be nimble when unexpected risk events take place.
- ASSET ALLOCATION: Totally passive solutions do not offer asset allocation as part of the management process; the choice of your strategic asset allocation is in fact an active decision.
STRIKING A BALANCE IS KEY
Each investor has their own set of objectives, so no two investment solutions will be identical. For all investors, however, the success of an investment solution can be measured according to whether they have achieved the objectives they set out to attain.
It is vital to remember that both active and passive products are required to create an optimal investment solution for every client. The key to success is understanding each client’s investment objectives, in order to strike the right balance between the two.
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