Active or passive: it’s always an active decision
The flexibility to choose between active and passive investment funds is an important part of our investment process.
Active managers investing in US companies have had a hard time beating the S&P500 in recent years. During this period the exceptionally strong performance of a few mega-cap stocks, largely concentrated within the tech and communications sectors, meant that not owning these companies – or even being underweight – presented a material headwind to relative performance.
With the benefit of hindsight, active managers should have held overweight positions in these companies. But this is easier said than done, especially when single stocks account for meaningful percentages of the index.
For example, at the time of writing, to be overweight in both Apple and Microsoft, a portfolio would need to own around 7% in each stock (or nearly 15% in the two together). While there is no inherent problem with this, a lot of managers may struggle from a diversification perspective. In the three years to the end of 2021, Apple and Microsoft outperformed the S&P500 by 264% and 142% respectively*.
It depends on what’s in the index
There are plenty of other cases where index composition has helped active managers generate better results than their benchmark index. In the wake of the commodity price slump of 2014-2016, for example, a majority of UK active managers outperformed the FTSE All Share. During this period, with energy and materials sectors accounting for a material portion of the index, avoiding or being underweight these sectors was a significant tailwind. In the three years to January 2016, the top-performing quarter of active managers beat the benchmark by 20% or more, according to data from Lipper.
Although these examples point to the importance of understanding index composition when reviewing passive investments, there are a number of other factors to consider when seeking to find the optimal solution in a given scenario. We highlight some of these below, but the key point is that investors should be pragmatic: there is no “rule book”.
What are active and passive funds?
Opportunity, risk and cost: finding the right strategy for the right market
So what factors help guide our decision-making? As noted above, understanding the composition of an index and its sensitivities is an important first step in considering whether a passive investment is an appropriate solution. As an extreme example, if you invested £1,000 in the MSCI Korea index today, over £250 of your investment would be held solely in Samsung Electronics.
Fees are certainly another consideration. Passive fund fees are typically significantly cheaper than their active counterparts, and this can have a meaningful impact on returns – particularly when compounded over the long term. As such, if selecting an active fund, we need to be confident that the strategy has the ability to generate sufficient excess returns to justify the additional fees. This will include a consideration of a manager’s skill, the opportunity set, and the level of active risk taken by the manager. It is also important to note that, particularly in nascent and niche areas, the differential between passive and active fees can narrow significantly.
“Market efficiency” is another factor that we look at. When there are large numbers of professional investors conducting detailed research – as is the case with large-cap US shares – it is generally harder to spot mispriced opportunities before anyone else does. This makes it more difficult to generate above-average returns from stock picking, suggesting that an index-tracking approach may be more appropriate. In markets with fewer investors – like small-cap shares – it is easier for active managers to beat the market.
Other market dynamics, such as volatility and stock dispersion, also come into play. When prices are experiencing large swings, and there are big differences in the performance of individual securities, active managers have a better chance of outperforming.
It should also be noted that we maintain this pragmatism across asset classes. Government bond markets tend to be both efficient and liquid, favouring the use of passive funds, but we are still able to take active positions around our benchmark by using specific passive investments. (For example, we might buy long-dated government bonds to increase our level of duration versus the benchmark.) On the other hand, the changing constituents of corporate bond markets (such as new bond issues and maturing bonds), coupled with generally poorer liquidity, makes it harder for passive portfolios to track effectively.
While it is important to consider the merits of active vs passive investments in each instance, it is equally important that we continually re-appraise our decisions. It’s possible (if not probable) that the variables that led us to a certain conclusion at a point in time will change in the future.
Sustainability: a key factor in the choice to use active funds
We believe that sustainability is likely to play a key role in markets for years to come, as regulators and consumers hold companies to account over their impact and how they contribute to issues such as climate change. Not all companies are addressing these challenges in the same way and we need to recognise the additional risks or opportunities that the transition to a sustainable economy brings. We cannot do that when we have to own everything in the index – it makes it harder both to avoid harmful companies and to select leaders that are adapting faster to the new world. We also believe we can play an important role in helping companies and managers transition to this new environment through engagement and voting.
As things stand, we are better able to reflect these views using actively-managed funds. Assessing a company’s sustainability characteristics is best done through detailed fundamental research, together with ongoing dialogue and company engagement. Passive providers still tend to rely on backward-looking, publicly-available data, which does not always provide a true picture of a company’s approach to environmental and social issues.
We would also expect managers to actively divest from holdings if they no longer meet our sustainability standards: this is generally not possible with passives.
Within sustainability portfolios, which seek to generate competitive returns and a positive impact for people and planet, we are therefore far more likely to use active approaches. For example, for bonds – in the absence of a common framework for what constitutes a social or green bond – we have a preference for active managers who can ensure the proceeds of each bond match the sustainable objectives of the investor.
But passive innovations are coming
Despite the above, we are seeing many innovative passive products being launched, including exchange-traded funds that aim to identify companies making the greatest progress towards decarbonisation targets.
A number of passive fund managers are also increasingly involved in engagement and voting on climate and social resolutions. However, the quality and scale of the activity varies by manager and it is clearly a challenge to ensure a consistent, rigorous approach given the volume of holdings within passive products. We believe it is essential that each ESG shareholder resolution is considered for its individual merits and the long term value it will create for shareholders, people and the planet.
The difficulty for investors is knowing which passive managers have this capability and are delivering on it – and which aren’t. We have developed a proprietary tool that allows us to understand the stewardship and sustainability capabilities of 180 active and passive managers representing £40trillion in assets under management.
As passive managers own such a large portion of global markets on behalf of their clients, improving voting and engagement practices could meaningfully contribute to creating positive change. We have been engaging with these managers to encourage best practice.
*Source: Refinitiv. February 2022
Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.