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Why durable portfolios need both active, passive strategies
Fund managers and investors need to ask themselves how to effectively incorporate the best of active and passive management to create a more durable portfolio.
Madeline Ho 16 Jan 2017
Passive investment strategies, mostly in the form of index funds and exchange-traded funds (ETFs), have taken off in recent years, mainly due to lower management fees and tax benefits. But with increased volatility in global markets this year, passive strategies have suffered from the fluctuation of the indexes they track, which in turn undermines returns.
The affordability of passive strategies and pervasive volatility in global markets has generated wide-ranging debates about whether portfolios should follow a predominately active or passive strategy, but this discussion should not center on an either/or proposition. Fund managers and investors instead need to ask themselves how to effectively incorporate the best of both types to create a more durable portfolio.
One of the greatest downsides of passive funds is that they do not manage risk, which is a crucial aspect all investors should consider first before investing into a portfolio. While 90% of institutional investors and 89% of financial advisors agree that passive investing is best for minimizing management fees and providing a low-cost way of achieving market returns, passive funds only buy market returns – both the good and bad – which exposes investors to volatile fluctuations in the market and makes no judgement about good or bad securities or market risks.
These are risks that investors need to better understand. According to Natixis’ most recent global survey of financial advisors, investors do not understand the risk in their passive portfolios. An alarming two-thirds of financial advisors think investors have a false sense of security about passive investments and do not understand the risks (75% in the US where passive is most common). In fact, since 1928, the S&P 500 Index has experienced a 10% correlation more than once per year, and a 5% decline more than three times per year on average. Passive investing will never outperform the market because it tracks the market.
Passive investing also does not align with what investors say they want, like investing in innovative companies that reflect their values. Index funds make no effort to separate the good from the bad, and the largest companies drive performance. Seventy-one percent of advisors say investors also don’t realize that index funds leave them exposed to “headline risks”, like corporate malfeasance, accounting irregularities, recalcitrant management, or environment disasters.
Furthermore, as the public debate focuses more on cost than suitability, investors are done a disservice. Passive investing has a place in portfolios, but with cost being made the only consideration, investors have come to equate low fee with low risk – a dangerous proposition for investors and a systemic risk for economies.
Price should never be the only consideration, and passive investing is not low-risk. Investing is about deploying the appropriate risk to achieve the right return, not just finding the cheapest product. Passive investment is not the silver bullet that will solve the problem of under-funded pensions, the lack of retirement savings, and the damage to emotional investment decisions. In fact, with no risk management, it can make these worse.
Rather than simply rank by cost, it is important to weigh cost against value. Value is ultimately why you invest, and what matters is whether a fund lives up to its value promise.
In contrast, active managers balance potential risks and rewards in a variety of ways, including finding opportunistic entry/exit points, hedging, capitalizing on short-term inefficiencies, and divergences between value, expectations, and price. These strategies are often more expensive than passive investing, but 58% of institutional investors say that over the long-term, active investments outperform passive, and are therefore willing to pay higher fees for active managers’ expertise and potential benchmark-beating returns.
Active managers also explore new frontiers for growth across industry sectors and regions, identifying companies that meet the requirements of their investors, and have greater leverage than passive managers to influence management and governance. This is crucial when a company is confronted with challenges, as active managers can serve as a crucial check against behaviour that may adversely impact shareholders.
Active strategies are not without their challenges. First, alpha potential is limited and only available to active managers at any given time, which explains the underperformance of active equity managers in 2014. But second, active investing has developed a perception problem in recent years, brought about by malpractice in the industry itself. Practices such as closet indexing, failing to limit the size of funds, launching trendy products, and failing to put investors first, have tarnished active managers’ reputations and forced some into passive investments.
While these strategies may seem at odds, better-educated investors who know these strengths and weaknesses will be in a position to produce a durable portfolio that uses both strategies to deliver returns and manage risk. Some market environments are more favourable towards active strategies, while others are more favourable to passive. The same can be said of asset classes too.
In a volatile global economy, the risks and opportunities within markets are constantly evolving. Pursuing one strategy over another will never truly deliver the returns investors wish to see. Adapting a portfolio to incorporate both and thinking about the portfolio for the long-term, even during periods of underperformance, will ensure value-added returns. 

Madeline Ho is head of wholesale fund distribution, Asia Pacific and executive managing director, Singapore of Natixis Global Asset Management Singapore. 

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