Active vs. Passive Fund management debate – Fund Selector’s view

In the below article Austen Robilliard, Head of Investments at Murdoch Asset Management will tell us about his view on Active vs. Passive Fund Management. Austen joined Murdoch Asset Management from Towry Law as a trainee investment analyst in 2007. Today he is their Head of Investments, responsible for managing advisory and discretionary portfolios, idea generation, training analysts and researching funds. Austen has become a well-known and respected analyst within the UKfunds industry, having been voted into Citywire’s Class of 2013 Top 30 Under 30, being a top-ranked member on Sharing Alpha and leading his company to winning multiple accolades with Investment Week and Portfolio Adviser.

The Active versus Passive fund management debate continues to rage amongst industry professional and private investors alike and with no end in sight.  On the one hand the active proponents readily cite Warren Buffett, Anthony Bolton, Terry Smith et al as proof it can deliver out-performance of the indices over time.  On the other, passive supporters can now add Neil Woodford’s catastrophic demise to their counterargument alongside high charges, questionable performance and risk of serious under-performance.

Tracking strategies will generally under-perform their chosen index due to charges – the higher the cost the worse the outcome, and there are also some technical issues with how they replicate the Index, whether they use derivatives and if they engage in stock-lending.  Returns from actively managed funds range wildly from dreadful to fantastic and anywhere in between.

As I head up our investment team now, training the next generation of fund selectors, I am still diligently involved in the fundamental investment research on a daily basis – there is no substitute for being at the coal face.  Over time I have researched active mandates, tracking strategies, hedge funds, quantitative and macro-economic vehicles, thematic plays… to name but a few of the multiplicity of systems available, but for me it always comes back to the same conclusion.

For the avoidance of any doubt, I sit resolutely in the active management arena and commend it, but only if you are up for the challenge of selecting and continually monitoring the managers you choose within your portfolio.  The best way for me to add value to my investors is finding managers who can deliver consistent alpha and being able to compound this excess return over time.

Whilst there is no budging the two polarized sides of the dispute no matter how much evidence is obtained or examples quoted by the other, many believe there is merit in combining both systems – but not me.  You may already have decided your stance or maybe open to evolving your style, so I want to highlight some potential pitfalls you face:

Combining active and passive funds

If you believe in active management, then buy active funds.  If you don’t believe active managers add value, then don’t buy any.  There are some asset classes where alpha is easier to find than others, so on the face it, why not have active management here and passives where alpha is trickier to find?  Whilst alpha might be hard to come by, it is available and expending that extra resource in finding it should pay dividends in the long run.  A central investment philosophy is vital as it keeps the portfolio focused on achieving specific goals and makes it easier to analyse whether the objectives are being met.

Duplication

Often portfolios hold multiple funds in the same asset class, which is sensible if done correctly but a real detractor if not.  What are your chosen funds doing?  Are they exposed to the same themes, do their holdings overlap and are their investment styles too similar?  Replication is undesirable as it lowers the diversification benefits and makes the portfolio more susceptible to shocks in those holdings.  When building portfolios, we are conscious of the negative effect duplication has, managing this risk through in-depth research and analysis.

Past performance

As investment themes play out it is tempting to buy in to the funds who have recently performed well and sell out of those lagging behind.  Having exposure to different assets classes and styles is key, as is being prepared to tolerate poor performance in the short-term providing you find know why and your manager can clearly justify their positioning.

Over-diversification

Should you have more holdings the more money a client has?  We often see an extensive list of holdings sometimes with as little as 0.3% or less allocated to a fund.  Generally intended to tackle concentration risk, what is that doing to achieve?  If it does brilliantly and out-performs by 20%, it only adds 0.06% to performance.  If you have conviction in a manager, the weighting should be meaningful and setting a minimum allocation level is just as important as having a maximum weighting. In conclusion, trackers reduce the risk of significant under-performance and require no ongoing intervention once set up to match your risk tolerance and investment aims.  If you have the resource, diligence and a robust process in place, it is possible to deliver above average performance particularly over the longer-term