A discussion, not a debate: lifting the lid on active and passive investing

by | Dec 5, 2022

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When carrying out investment due diligence for your clients’ investments, the decision between whether to select an active or passive approach is key. Brooks Macdonald, highlight how and why when considering an active or passive investment approach, there is a whole lot more to it than just cost.

The relative merits of ‘active’ and ‘passive’ investing are a well-worn debate in the financial services industry. As an adviser, would you prefer a fund manager to actively manage your clients’ money? Or perhaps you’d prefer their investments to simply track the market? Either way, understanding the difference between active and passive fund management is important, as each bring different merits and relative costs for your clients.

What is the difference between active and passive investing?

The job of an active fund manager is to buy and sell investments. This involves consciously making decisions based on their view of the investment’s prospects, choosing where to invest – and which risks to take – with the aim of delivering a performance that beats the fund’s stated benchmark.

 

Passive fund managers don’t have to pick which investments to hold in their funds and returns depend almost entirely on the performance of the index being tracked. Passive investing involves tracking a selected market index and, by doing so, delivering a similar level of performance to that market. The fund manager simply replicates the movement of the market they’re tracking, rather than trying to outperform it. Typically, management fees will be lower for passive investments, which are promoted as low-cost ways of investing.

Performance potential

Managing investments usually involves a balancing act between delivering an attractive level of return while taking an appropriate level of risk and incurring a reasonable level of cost.

When it comes to the management of multi-asset portfolios, there are three main approaches to gaining investment exposure which are selecting:

 

• active underlying investments

• passive underlying investments

• A mixture of active and passive approaches

 

Which approach is taken will impact the investment decisions that are made and the outcome, so it’s important to understand how the risks and opportunities might differ between active and passive investing – specifically in relation to, performance potential, risk control and the available investment universe.

Active managers can seek out those investments in which they see most value, aiming to outperform the market. But, of course, there are no guarantees. There is always the potential to both outperform and underperform after fees. The success of active managers is driven by their investment decision making, so it is important to thoroughly understand what drives this – looking at, for example, what they invest in and why, their investment style, their risk characteristics, and performance in different market conditions.

Passive investments aim to track the performance of a chosen index by replicating it, rather than outperforming it. There are a number of different ways of replicating and, while management charges are usually low, they are still incurred. Again, careful analysis of the investment is essential as this combination of factors means the actual performance of the passive investment may end up differing slightly from that of the index.

 

Intended and unintended exposures

Regardless of whether an active or passive investment is used, having an awareness of the size of underlying allocations is important.

In an active investment, a conscious decision is taken by the manager to allocate to a particular investment area. The manager will likely consider the size of this allocation in relation to the rest of the investments, and the level of risk they wish to take.

The concentration of passive investment exposure is purely driven by the composition of the underlying index being tracked. There are a huge number of passive investment products available, but regardless which is chosen, it’s important to understand what the underlying allocations are, and how they may change over time as the index changes. If an investor does not consider how the composition of an index might change, they could end up with allocations that are not in keeping with their wider investment aims.

 

An understanding of underlying risk exposure is equally important when it comes to fixed income investing – e.g., the level of duration or credit risk. Active investments can alter their exposures in these respects, but passive investments cannot. Having concentrated exposure or taking certain risks isn’t necessarily a bad thing, but it’s important to understand exactly what risks are being taken, whether through an active decision, or because of tracking a certain index.

Accessing an expanded opportunity set

Another potential benefit of active investments is that they can increase the range of opportunities on offer.

Beyond investing in equities and traditional fixed income, the wider investment universe provides opportunities for multi-asset portfolio managers to access more sources of potential growth, income and diversification. While there are some passive options available to gain exposure to these, certain areas can only be accessed using active investments as no suitable passive investments exist.

 

Investment opportunities can be found within real estate, infrastructure, music royalties, renewable power generation, structured products, energy storage, alternative income, healthcare royalties and other specialist strategies, as examples.

While they may present attractive opportunities in terms of alternative sources of growth, income or diversification, these more unusual investments do have specific risks, and therefore an experienced management team with the ability to conduct rigorous due diligence and actively manage exposures is essential.

Bringing it all together

When it comes to active and passive investment strategies, it isn’t the case that one size fits all. Understanding the risks and opportunities associated with each in the context of overall portfolio objectives is key.

At Brooks Macdonald, we have both strength and depth of investment resource, and apply substantial rigour to the selection of all underlying investments used in the construction of our portfolios. Taking a hands-on role in overall portfolio management allows us to take advantage of the investment opportunities and manage any risks as they arise.

In this challenging environment, having the flexibility to seek out and allocate to sources of potential growth and income from across the broadest possible investment universe, and the freedom to adjust these allocations as the outlook changes, is a powerful combination.

Our SVS Cornelian Risk Managed Funds and SVS Cornelian Risk Managed Passive Funds, consist of eleven funds across five different risk levels – providing choice and flexibility when selecting a multi asset investment solution. The funds are widely available on all major platforms. For more information, please visit the Brooks Macdonald website.

Important information

The information in this article does not constitute advice or a recommendation and investment decisions should not be made on the basis of it. This article is for the information of the recipient only and should not be reproduced, copied or made available to others. The price of investments and the income from them may go down as well as up and neither is guaranteed. Investors may not get back the capital they invested. Past performance is not a reliable indicator of future results.


For more information about Brooks Macdonald, click here

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