While the ‘active versus passive’ debate so often claims headlines across our industry, we believe both investing styles have pros and cons and both have important roles to play in successful multi asset investing. Here, Paul Nash, Multi Asset Investment Director explains how the two styles can be used in harmony across asset classes to benefit investors.
When to go active and when to go passive
Investor preferences about risk, return, cost, and time horizon are all important factors in deciding when and where to lean towards active or passive management. For example, investors who prefer to keep costs low tend to prefer a greater proportion of passive instruments, while investors who want to achieve specific return, risk or income objectives will often find active strategies better suited to meet their needs.
Broad market conditions are also a key consideration. Active strategies have tended to perform better in periods of market turbulence because managers are able to manage positions dynamically based on incoming information and can make flexible use of cash and flows as dry powder when markets are under pressure if necessary. Passive strategies, however, are dictated by market capitalisation and only rebalance periodically, meaning flows cannot be dynamically managed.
Active strategies tend to benefit from smaller stocks performing well relatively to the benchmark, whereas passive strategies are difficult to beat when larger stocks outperform, especially when market concentration is high. Passive funds can be a good way to gain exposure to the US and global sectors, which are well-covered from a research perspective and where index concentration is high (top 10 securities comprise 30% of the MSCI US index1). When markets are driven by sentiment, passive strategies tend to do well because active approaches are often managed with a bias towards fundamentals over price movements. Finally, when market dispersion is high (when the variation between the returns of the individual stocks or bonds in an index is high) - active strategies tend to benefit because there is a greater opportunity for skilled investors to outperform the benchmark by selecting the best performing securities.
Pros and cons of active and passive
What are the benefits of active management?
- Beat the market: Active investing provides the opportunity for outperformance either by stock selection or asset allocation decisions, while passive investors will only get the broad market return minus costs. It should be noted that all asset allocation decisions are active, so that even tracking an index requires a choice to be made about which index to track, which can be a significant factor on overall investment performance.
- Flexibility: Generally, active approaches can invest more freely than their passive counterparts as they’re not tied to an index.
- Risk management: Active managers can minimise potential losses by avoiding certain companies, sectors or regions. Passive investors are required to accept an index, however constructed, and regardless of the quality or price of the underlying holdings of that index. Given that most indices are based on market capitalisation, it can lead to an emphasis on larger companies and sectors or paying up for those that are in vogue.
What are the benefits of passive investing?
- No underperformance: It’s unlikely that a passive fund will underperform the market index by a material margin. Active management, on the other hand, requires a lot of skill, especially in highly efficient markets, and underperformance is a possibility.
- Low cost: Management fees of passive strategies are usually lower than those of an actively managed fund.
- Simple: Passive strategies offer a quick and easy way to gain access to a market; little additional research into manager style and skill is required.
- No key person risk: The process can be easily followed and doesn’t rely on any one individual, which can sometimes be the case for actively managed strategies.
The best of both worlds
Both active and passive approaches have strengths and weaknesses. Blending the two allows us to take advantage of both, offering a mixture of the potential for superior investment outcomes and lower costs depending on what our clients prefer.
We advocate taking a long-term diversified approach to investing. The Fidelity Multi Asset Allocator range and Fidelity Multi Asset Open ranges are good examples of diversified fund ranges which give investors the option to select the level of risk they are comfortable with. Both invest across asset classes and regions, supported by a well-resourced and experienced team of research analysts, and are not constrained to using only Fidelity managed funds.
Our Multi Asset Allocator range offers broad-based and diversified exposure to global financial markets, implemented using low-cost index trackers and exchange traded funds (ETFs). The Multi Asset Open range primarily invests in actively managed strategies and looks to capture alpha by analysing the broad drivers of markets.
1 FactSet as at 29th February 2024.
