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Portfolio Construction

Dynamically blending active and passive investment strategies plays a key role in constructing suitable multi-asset portfolios for clients, believes Nick Samouilhan, multi-asset manager, at Aviva Investors

 

Legendary investor Warren Buffett re-ignited the debate between active and passive investing earlier this year. He disclosed to shareholders of Berkshire Hathaway that he wants the bulk of his wife’s bequest invested passively after his death.

Rather than rejecting an active or passive approach outright, as many do, we believe there is room for both approaches in a diversified multi-asset portfolio. Our role is to find the best blend of active and passive strategies to meet our clients’ investment objectives.

Setting the Strategic Split

When it comes to constructing suitable portfolios for clients, remember that the choice of active or passive approaches is secondary to asset allocation. Asset allocation aligns the portfolio with long-term risk and performance objectives. So, when constructing portfolios the focus should remain on getting asset allocation right. Only once asset allocation is known can the choice between active and passive begin.

Market Efficiency

Some asset classes can lend themselves more to active management than others. For instance, emerging-market equities and high-yield bond markets tend to have structural and informational inefficiencies that help active managers add value. So, we may have larger actively managed allocations in such asset classes.

 

By contrast, passive strategies are often appropriate in more efficient, liquid markets such as US equities and UK gilts which attract a large pool of investors. Active managers typically struggle to add value consistently in efficient markets, increasing the risk they underperform the market. You can tilt asset classes less well suited to active management, such as emerging markets and high-yield bonds, to passive investments. This reduces costs and can free resources.

 

Holistic Approach

The active/passive decision should be integral to the overall portfolio construction process. Looking at an active manager in isolation may inadvertently increase style or sector bets if their skill and style are already present via other managers in your portfolio. A more holistic approach may reveal, for instance, that all active managers in your portfolio underweight the financial sector or emerging markets. Unless you want these compounded biases, employing more passive management may help dilute such bias.

 

Risk Control

The active/passive split may help control portfolio risk levels by dynamically allocating a risk budget between strategic asset allocation, tactical asset allocation and investment selection. The active/passive split can adjust the level of risk allocated to the investment selection. The process is dynamic as asset-class risk premiums and cross-asset-class relative opportunities constantly change.

 

The investment time horizon matters when blending active and passive approaches. Active managers usually aim to outperform over the long term, though periods of short-term underperformance are not unusual. So, clients with short investment horizons tend to prefer passive managers, while clients with longer-term goals typically bias portfolios to active managers.

 

Total Portfolio Perspective

Approaching the active/passive decision from a total portfolio perspective should help you to construct suitable multi-asset portfolios for your clients. We believe dynamically blending active and passive strategies, adjusting the blend when appropriate, provides a better proposition than a ‘one or the other’ approach.

 

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