It is universally agreed that asset allocation is the biggest driver of returns within an investment portfolio. However, having established what your asset allocation should be, a further important decision remains – What investment strategy should you adopt when investing your capital within each asset class?
The options an investor has can be split between two clearly defined strategies, namely active and passive There is a significant amount of information available on these two investment styles, however in this note we do not directly reference any particular paper or publication, but instead outline what we believe to be the most generally accepted consensus view.
The Components of Risk
The level of long term return offered by an investment is closely related to the possibility of loss. The greater the possibility of loss, the greater the expected return needed to make the investment worthwhile.
Investment theory defines two components to risk, ‘specific’ risk and ‘non-specific’ risk, the sum of which provides the aggregate risk on an investment.
Non-specific risk, sometimes called market risk, is the risk associated with simply being invested in a particular asset class e.g. the UK stock market. Specific risk on the other hand, is the risk associated with investment in a particular security rather than the stock market in general.
The effects of non-specific risk are felt, for example, when an investor experiences losses when the UK stock market as a whole declines reducing the value of his/her portfolio. Whilst specific risk is felt when, perhaps the stock market as a whole rises, but the shares held by an individual investor decline in value.
What is ‘Passive’ Investing?
Passive investment management seeks to reduce aggregate risk by eliminating specific risk. Passive investment involves the investment of each asset class within a portfolio to mirror, as closely as possible, the movements of the index it seeks to match. A typical modern example is an Exchange Traded Fund based around the FTSE ALL Share Index. An investor into such a vehicle will experience no specific risk, and will solely participate in any gains or losses of the actual underlying index.
What is ‘Active’ Investing?
An active investment mandate intentionally embraces non-specific risk by building a portfolio of securities that will diverge from the movements of the underlying market. The active manager seeks to identify baskets of securities that in aggregate will behave differently from the market as a whole with the intention of achieving a greater performance over the long-term.
Which strategy is right?
Whilst both methods offer value to the investor, they also generate heated arguments amongst their respective proponents. The primary focus of the argument is whether active funds do actually produce the long-term returns required to justify both the additional risk and cost.
The answer to this question is not straightforward.
Undoubtedly most academic research suggests that on average, fund managers do under-perform the index in which they invest. Of the active funds invested into typical large markets, say large capitalisation equities in the UK or US markets, only some 20% manage to outperform their comparable indices in any specific period. Moreover, there is little evidence to suggest that those that do outperform have any greater statistical probability of repeating the feat in subsequent years. In this, lie the most forceful arguments in favour of a passive investment strategy.
However proponents of active investment have two counter arguments.
First, it is wholly unlikely that every fund manager has no more than a random chance of success. There must logically be fund managers possessing an ongoing greater level of ability than their peer group. There are certainly a few individual fund managers who seemingly are superior in aggregate track records than statistical fluke would allow. The most likely explanation of success is superior ability.
Secondly, and probably the more compelling argument is that active investment management is actually a lower risk proposition than passive, because in times of difficult markets the active manager can take steps to mitigate losses by careful security selection, whereas the passive manager has no choice but to watch their portfolio decline.
This latter point, if true, is powerful. However, it is worth noting that the active investment industry with its vast research and marketing resources has not been able to prove this can be consistently and predictably achieved.
The value of investments and any income from them may go down as well as up and you may get back less than the value of your investment.