There is much debate at the moment about whether inflation has peaked and, if it has, what does the outlook for interest rates look like?
At the same time, there continues to be another rumbling contest in the investing world between active and passive approaches.
Of course, the active versus passive debate seems to be older than time. Ever since John Bogle created the first passive mutual fund in the US way back in 1975, the merits of paying more for going active or less and tracking indices have been the subject of fierce debate. However, the outperformance of passive funds in 2022 has intensified this debate, and once again, we are being asked for our views on the relative merits of both styles.
From the outset, it is worth restating that our fundamental approach to the active versus passive debate is that they both offer potentially distinct benefits in different situations. Therefore, we always start with the balance of probability test, effectively: ‘do we think a given active fund can outperform a passive alternative net of fees provided the market conditions?‘
So, the use of passive funds tends to ebb and flow over time, given the prevailing market conditions.
Performance This Year
The US is notoriously known as one of the most challenging stock markets for active managers to outperform in. This may have been highlighted more than ever in 2022, as year-to-date US active funds have witnessed net outflows of $250bn, whereas fund flows into passive funds have amassed $400bn.
If we look at what happened this year, passive funds have gone through one of their best performance periods, having outperformed most active strategies in 2022 (IBOSS portfolios included). A large part of this is due to the dollar’s strength and large companies outperforming mid/small-cap equities.
The result is that we do now have more investors looking seriously at our passive portfolios. Simply put, they have performed well, are attractively priced, and provide a relatively straightforward conversation with clients.
The critical question investors must ask themselves is whether the world has changed to such an extent that successful active management can no longer generate Alpha? We do not think this is the case, but we keep an open mind concerning the circumstances of where we should use active or passive funds.
Our Current Portfolio Positioning
We currently use roughly 75% active and 25% passive weighting within our equity allocation. It’s imperative to understand what a passive vehicle is tracking to know when it will do well and when it will struggle.
Given that we discussed the US at the outset and that it is the most often-used example of the most challenging stock market for active managers to outperform, let’s look at how we are investing there. We use the L&G US Index Trust, which closely follows the S&P 500 and is growth orientated, so we know what to expect from it. We pair this with the actively managed M&G North America Value fund. These funds have little commonality, but it’s the M&G fund that has taken advantage of recent market volatility. The manager’s value discipline and off-benchmark positions have outperformed the index following the Fed’s acceptance that inflation is, and has been, a concern.
Of course, the active versus passive debate has evolved. It’s different for each sector, and if you look at why passives have generally outperformed this year, again, the evidence is multifaceted. The most striking exception in our own range, bizarrely, is our American holdings, with the M&G fund performing much better than the S&P 500. However, in most regions, passive funds have performed better than their active counterparts.
Passive Allocation to Specific Sectors
There are also certain situations where we want to keep a greater degree of control. For example, in the last few weeks, we have increased the duration of our bond allocation, and we have done this via a passive fund; the Vanguard US Government Bond Index (Hedged). This gives us a high degree of certainty about the asset make-up, duration and currency. We blend several funds in each sector, and if we used purely active managers, we would have limited visibility of the overall make-up of portfolios.
In the coming months, we expect to add further to active funds as we see new opportunities opening in the fixed-income sector. This will end our extremely short-duration position, which we managed via passive funds and has helped protect capital for our lower-risk clients.
We have had a higher passive weighting in the bond space because the active managers had no interest rates to play with. Managing credit alone was unlikely to generate sufficient Alpha, even if they got most of their calls right. It is worth noting that the bond managers across the asset class we have been speaking to are genuinely excited about their positions for the first time in a long time.
Which approach do wealth managers think is best?
This is a question we get asked quite frequently by advisers, and one that isn’t straight forward or easy to answer.
With the expanding range of passives in niche sectors such as emerging markets, China and high yield etc. It has been suggested that passives can offer a replica for all active approaches. Although this is true, as uncertainty increases we feel there is a benefit to having ‘multiple voices’ in a portfolio. Using purely passive holdings will only reflect the view of the overall portfolio manager. Holding a range of active funds can help broaden this view and diversify away a portion of the manager-specific risk.
In summary, we believe that in both bond and equity markets, we may move from a beta-driven market (a situation where you are rewarded for taking broad market risk) to an Alpha-driven market (one where active decisions become the driver of returns).
However, the current situation is just too uncertain to be all in one camp and we feel a blend of both is a sensible approach.
This communication is designed for professional financial advisers only and is not approved for direct marketing with individual clients. These investments are not suitable for everyone, and you should obtain expert advice from a professional financial adviser. Investments are intended to be held over a medium to long term timescale, taking into account the minimum period of time designated by the risk rating of the particular fund or portfolio, although this does not provide any guarantee that your objectives will be met. Please note that the content is based on the author’s opinion and is not intended as investment advice. It remains the responsibility of the financial adviser to verify the accuracy of the information and assess whether the OEIC fund or discretionary fund management model portfolio is suitable and appropriate for their customer.
Past performance is not a reliable indicator of future performance. The value of investments and the income derived from them can fall as well as rise, and investors may get back less than they invested.
IBOSS Asset Management is authorised and regulated by the Financial Conduct Authority. Financial Services Register Number 697866.
IBOSS Limited (Portfolio Management Service) is a non-regulated organisation and provides model portfolio research and outsourced white labelling administration service to support IFA firms, it is owned by the same group, Kingswood Holding Limited who own IBOSS Asset Management Limited.
Registered Office is the same: 2 Sceptre House, Hornbeam Square North, Harrogate, HG2 8PB. Registered in England No: 6427223.
IAM 325.11.22
