Being active about your passive portfolio: how to invest in passives well

  • Investment management
  • 4 minute read

Passive investing continues to grow in popularity, with the amount invested now topping ~$5 trillion globally[1]. The sector continues to evolve, with new products and innovations driving the growth of the sector. But the active versus passive debate continues to dominate much of the conversation.

While the discussion around different management strategies is important, the language used is often too blunt. It can lack the necessary nuance to deliver meaningful insight into the different strategies and their benefits. The key distinction is between rule-based investments and discretionary strategies, each of which offers distinct benefits for the end investor.

Rule-based investments are ‘passive’ as once the rules are in place, little if any marginal discretion is given to the portfolio manager. For example, a fund could simply track the FTSE 100 or a commodities market like gold. If economic or investment circumstances change, however, the manager may be able to switch to a different provider of the index; it is this ‘light-touch’ management that would be reflected in the associated fees. Rule-based investments can be just as concentrated and carefully compiled as discretionary portfolios; for example, smart-beta investing uses far more granular rules (looking at behaviour or specific financial metrics), while high conviction firms are made up of an analysts’ best performing stocks. Smart-beta passive portfolios may have as few as 50 stocks, and ‘high conviction’ discretionary portfolios hold 20-40. This strategy is likely to be favoured by investors who are more analytical – it’s easier to monitor and the diversification of the larger more popular indices lessens the idiosyncratic risk (that is, the risk caused by a single asset going wrong rather than the system going wrong).

This contrasts markedly with discretionary strategies. These are compiled and changed on a regular basis depending on the manager’s personal preferences, investment strategy and outlook on the current market. They benefit from having the option to offer downside protection in falling markets and can also increase risk exposure on the upside. However, without a high calibre manager and appropriate investment approach, this potential often goes untapped, and the cost of the manager can outweigh the returns.

If you’re considering enhancing your rule-based (passive) holdings Weixu Yan, Investment Manager at Close Brothers Asset Manager, outlines some key questions to consider.

Decide your risk level

All investing should be for the medium to long term (at least 5 years), and everybody has a risk level they’re most comfortable with. To evaluate your risk profile you need to balance your willingness to take on risk with your desire for a higher return. This profile will help you decide on your asset allocation of choice – for example, mid-cap indices are more volatile than the large-cap, while small firms have a higher liquidity premium (they’re traded less and you may find it difficult to get your money out, so you want higher returns for your risk.)

Consider your areas of interest

Your risk profile will narrow down your options, but then, you need to consider where your interests lie. If there are sectors that catch your eye, it is likely that there will be passive funds in those areas. Be careful not to fall into common sector traps though – there are many new classifications now. For example, Google used to fall into technology but is now classified as communications. If you’re looking to invest in the tech-giant FAANGs (Facebook, Apple, Amazon, Netflix, and Alphabet’s Google), 4 of the 5 aren’t even classified as tech companies.

If you’re interested in ethical investing, there are ethical indices. Methodology is key here so it’s vital to do your research. However, if ethical investing is your top priority then a discretionary (active) fund is likely to be right for you – rule-based investment struggles to account for the subjectivity.

Research an index

Once you’ve identified your risk appetite and your areas of interest, it is more straightforward to narrow down the indices you want to invest in. There are far more indices than stocks as an index can contain any combination of a set number of stocks; this is not unlike the periodic table of elements making an infinite number of materials. It’s important to do your research to work out which one suits you.

A low-risk low-effort tracker could track the FTSE 100, but there are far more niche rule-based investment strategies out there too. For example, smart-beta portfolios tend to be extremely research-led and can focus on certain factors like dividend, size, value or growth. Others can focus down on sectors or geographical locations like Europe, Asia Pacific, and Emerging Markets if you don’t like single country exposures etc.

Research the providers

Once you’ve chosen an index, look at which providers could deliver it. It’s crucial to do your due diligence on the ETF (exchange-traded fund) or index fund providers, marking sure they have an efficient team, relevant experience and tools to track the index you’ve chosen. For example you may prefer a global asset manager to track your global equity exposure as they would have global reach and access to the foreign equity markets.

At Close Brothers, we dedicate comprehensive research strategies to exactly this. The firm-wide view on the best assets is implemented across all three investment strategies (passive, active, direct equities).

Check the cost

All investment comes with a cost, but it’s not just the headline cost you need to consider. May saw the first ever negative-fee ETF approved in the US, but this is merely headline grabbing and masks the reality. Different indices come at different costs, with smart beta being costlier than trackers on simple indices like FTSE 100 and S&P 500. Generally, passive funds involve less buying and selling and therefore tend to be cheaper than their discretionary counterparts.

Passives are a great way to get people investing, and the most successful portfolios have a mix of investment strategies contained within them. But while they are notably more accessible, it can still be a tricky landscape to navigate. Whether you’re new to investing or just looking to balance your costs and returns, speaking to an adviser can really add value and help establish the best options for each situation.

Remember, your investments may go down as well as up and you could get back less than you originally invested.

[1] https://www.closebrothersam.com/for-financial-advisers/news-and-insights/inside-passives-smart-beta/ from Citi Research: Riding the Passive Wave, with kind permission 27.02.2019.

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