This is the second part of my discussion on some of the things investors need to consider when choosing between active and passive investment strategies in their portfolios. In my last post a few weeks ago, I provided some definitions to help you understand the ‘lay of the land’. In this second post, I discuss some of the considerations that investors may want to take into consideration when deciding which style of investment approach to select. Let’s get into it:
So what should an investor take into consideration when deciding whether to select active or passive investment strategies? Some of these considerations include:
How efficient is the underlying market?
There are segments of the market that are known to be inefficient. If a market is inefficient, then there is opportunity to exploit and take advantage of mis-pricing within that market which could result in outperformance, or “alpha”, being generated. This is where active management and/or Smart Beta/rules-based strategies come in handy.
Two markets which are generally regarded as inefficient, and where active management or rules-based strategies have historically tended to outperform passive index funds, are the hybrids and small-cap markets.
Using hybrids as an example, additional value an active manager can potentially add over an index-tracking approach is access to deeper liquidity and improved trading costs, specialist knowledge to assess the complex and varied issuance terms of securities, and the ability to sell securities when they become overvalued.
To access an actively managed portfolio of hybrid securities, BetaShares offers the Active Australian Hybrids Fund (managed fund) (ASX code: HBRD).
Whilst active managers have performed well in the small cap space, we believe that most of the outperformance in the sector can be achieved by identifying and avoiding companies with undesirable investment characteristics. This can be achieved with some sensible screens, delivered in a cost-effective way.
To access a small-cap portfolio constructed using a series of extensive screens, BetaShares offers the Australian Small Companies Select Fund (managed fund) (ASX code: SMLL).
Where are we in the market cycle?
Market cycles may influence which strategy you may like to consider. In a momentum driven market, where markets are generally moving higher, there may be no need to look at active or Smart Beta strategies. “A rising tide lifts all boats” is the saying, and in a momentum driven market, just having exposure to the right sector may be all that is needed.
However, as a market peaks and corrects, market pull back and risks may be mitigated by using a strategy that is active or rules-based, which will hopefully have exposure to higher quality securities that will be less affected.
High volatility or trendless markets present another opportunity where active and Smart Beta strategies can take advantage by being in specific securities, sectors, or where alternative strategies that are defensive, or not as correlated to rest of the market, can shine.
Yield strategies have always been popular for Australian investors. A few years ago, with interest rates heading to all time lows, markets were strong and, with positive earnings, most yield stocks performed well.
The market environment is a lot different today. You have the Royal Commission hanging over the banking sector, with many analysts predicting that the big four will struggle to grow their earnings and therefore their share prices in the years ahead. Interest rates look like they are set to rise again, which would impact interest rate sensitive investments, and many feel the top 20 stocks on the ASX will have a difficult time achieving growth.
Two actively managed funds to help navigate the current market environment in their chosen sectors are the BetaShares Legg Mason Equity Income Fund (managed fund) (ASX code: EINC) and Real Income Fund (managed fund) (ASX code: RINC).
For funds with a specific income objective, active management can add value by navigating the markets in changed market conditions and that’s exactly what Legg Mason set out to do in EINC, aiming to deliver an attractive, tax-effective and low volatility income stream that can increase with inflation, targeted at retirees and low-tax paying investors.
REITs or Real Estate Investment Trusts exhibit sensitivity to interest rates. However, active manager Legg Mason has diversified the portfolio of RINC to also include other real assets such as infrastructure and utilities, which is a combination not typically seen in stand-alone listed property or infrastructure funds. The combination of the three sectors also lowers the interest sensitivity of the portfolio compared to stand-alone REIT exposures.
Is the added cost for active or rules-based strategies worth the money?
When I go shopping it’s all about value. If I am looking at two similar shirts, I don’t necessarily purchase the cheapest. I consider the quality, because if one shirt is going to last, say, 3x longer and I only need to pay a bit more for it, in the long run it is going to cost me less. The same goes for investing. If I am going to pay more, will there be enough outperformance in the long term that will justify the added cost? Management fees eat into your returns over the years and, although an active manager may outperform their benchmark, after considering their fees you may be worse off.
The cheapest Aussie equities exposure in the world is currently the BetaShares Australia 200 ETF (ASX code: A200)*. For only 0.07% per annum you can get access to the largest 200 companies listed on the ASX. However, this is a market cap weighted index and if you are looking for something that may potentially outperform the market over the long-term, BetaShares also offers the FTSE RAFI Australia 200 ETF, which uses a Smart Beta approach to weighting its index and has outperformed the market cap weighted index over the long term by ~2% per annum**. With a cost of 0.40% per annum, I believe there is real value there.
Depending on what sectors of the market you are looking at and where we are in the market cycle, active management and Smart Beta/rules-based strategies may add value. However, active is not necessarily the best option in every situation and if you have an option that is cheaper and can outperform in the long term, then going with plain index and/or Smart Beta/rules-based strategies makes sense. When all is said and done, in my view, there is no debating that both active and passive strategies can be used in conjunction with one another and both should be part of a diversified portfolio.
That concludes my two part series on Active versus Passive management. Stay tuned for more!
*Source: Bloomberg, based on expense ratios of Australian shares ETFs traded in Australia or on overseas exchanges.
** Source: Bloomberg. FTSE RAFI Australia 200 Index v S&P/ASX 200 Index, 1992 to June 2018. Does not take into account ETF fees and expenses. You can’t invest directly in an index. Past performance is not indicative of future returns.