One of the most fundamental aspects of investing is the decision between active and passive approaches to portfolio management. Each has their own objective and is suited to certain circumstances, in particular the prevailing monetary conditions.
Passive asset management
Passive asset management aligns the growth asset profile of the investment with a particular risk profile, from conservative through to high-growth. The manager will also attempt to offer a diverse and stable mix of the major asset classes and, within those asset classes, try to track the underlying market. Other objectives are to maintain a highly-liquid portfolio and maintain it at a low cost. The buy-and-hold nature of a passive approach lends itself to low-cost investing, as transaction costs and management fees are typically lower due to a lower velocity of trading.
Well-constructed, a passively-managed portfolio will effectively replicate the universe of investment products within the bounds of the fund, often the liquid listed product base of equities and bonds.
Investors and managers alike must be comfortable that when the market corrects, the fund will move with it; the intention being that over the long term, these corrections will be ironed out by market gains. In fact, managers of a passive fund will usually be more concerned when it fails to correct with the market, indicating a tracking error with the composition of the fund.
Active asset management
Rather than tracking market performance, active funds seek a target rate of return. They offer a point of difference with the broader universe of investable instruments, to which most Australians are already heavily exposed through their superannuation.
Active managers find their edge through investing in selected assets from similar classes to typical passive investments, but also employ a greater bandwidth at an asset class level to exploit different types of opportunities.
The performance of an active fund can be assessed via a hit rate, which measures the percentage of time where it exceeds its target return.
Different market conditions favour differing approaches
Over the past decades, as the developed economies have experienced a period of relatively stable monetary policy, passive management has become an increasingly popular strategy. In times of low volatility such as these, it is generally more difficult for an active manager to find an edge, or to generate alpha (i.e. excess returns) net of transaction costs over and above the market return.
However, with the scope for further monetary easing diminished, and uncertainty around global trade, and government policy more broadly, the global economy could be entering a period of increased volatility, which better suits an active approach to management. In this environment, the uneven effects of global events, overlaid on individual asset fundamentals, create opportunities for those managers who are able to generate genuine insights and add real value to their portfolios.
Within AMP, there are two groups of funds that typify these two approaches.
The MyNorth index diversified funds (MIDF) are managed according to a passive strategy: structured to meet a generic risk profile with the aim of closely tracking market indices. Their asset allocation is stable and diversified across the major asset classes, and they thrive in low-volatility markets at times where the major asset classes of equities and bonds are performing strongly.
In contrast, the Dynamic Markets Fund (DMF) is managed against a real return target of CPI1 + 4.5%. The group of assets to which it is exposed are dynamically managed through the course of the cycle, and include the major asset classes as well as a selection of minor asset classes such as commodities, currencies and other hedges.
While these portfolios are each suited to particular market conditions, it’s important to bear in mind that other factors should come into play when determining an approach, including the individual goals and risk appetite of the investor and investment horizon.
The choice between passive and active investment management is seen by many as a zero-sum game, when in truth many investors will allocate capital across both strategies. The question for the investor should therefore not be “which strategy”, but rather the proportion allocated to each and at what time.
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