Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here James Bateman, Head of Portfolio Management, Fidelity Solutions, discusses how active and passive strategies can work together in a portfolio.
The ‘active versus passive’ debate has become part of the furniture for investors in funds, where each of these types of strategy offers a different set of risks, costs and benefits over time. While active managers can add value through their expert stock selection and research capabilities, passive ‘index-tracking’ strategies can provide broad access to markets, offering diversification at lower costs. Which is better for investors overall? There’s no ‘right’ answer, and no need to make a philosophical choice between the two – if combined intelligently, they can work well together in an overall portfolio.
Know Your Markets – Active Management Works Better In Some Than Others
When combining active and passive strategies, it’s important to remember that no two markets are the same, and that each of these types of approach can offer varying opportunities depending on the asset class and region. For instance, active management makes good sense in less efficient equity markets, such as Emerging Markets and smaller companies.
Similarly, asset classes such as high yield bonds and emerging market debt (EMD) do not suit a passive approach, given the asymmetrical returns from credit. On the other hand, more efficient developed markets such as large cap US equities can be less fertile for active managers, since mispricing opportunities are scarce. In this context, a passive approach that offers blanket coverage can give access to broader market growth.
Not All Passive Strategies Are Created Equal
I think the ‘active versus passive’ debate is something of a red herring for more experienced investors, distracting from the bigger and more specific questions about which types of active or passive instruments to consider. As the investment universe expands in each of these directions, it’s important to understand the differences between them.
This is no easy job – at Fidelity Solutions, our 12-person Strategy Selection team is dedicated to finding the right instruments for our clients’ portfolios. While it may be easier to outsource this research to a team of professionals, there are some key areas that self-directed investors can consider.
Among active managers, the choices are clear: quality or value, growth or defensive, bottom-up or top-down. But many investors are less familiar with the scope of options among passive vehicles, including a proliferation of so-called ‘smart beta’ approaches which offer more routes to low-cost diversification than ever before. For instance, a smart beta strategy like the S&P US Dividend Aristocrats ETF provides exposure to those companies in the US which have consistently increased their dividend over the last twenty years.
It’s not active management, but it isn’t quite ‘passive’ either. I think this balance will become increasingly appealing to investors over the next few years, but the key to their success will be about how they can combine with other strategies over time.
Making a Smart Combination
There’s no single correct way to combine active and passive strategies in an overall portfolio. Instead, this is about understanding where these approaches work, and why. This is not a philosophical choice – it’s a practical one, and I don’t believe there are many investors today who stand too rigidly on a single side of the ‘active versus passive’ debate.
Deciding on the optimal instruments for inclusion in a portfolio is about understanding your specific investment objectives, whether those are related to risk, costs or specific preferences for individual regions or asset classes. It also has to do with your time horizon. For instance, shorter-term tactical views are typically best played through passive strategies, giving direct exposure to the movements of particular markets. In the longer term, active approaches, particularly in less efficient markets, can add significant value.
When investing over a longer period of time, I would argue not only that active and passive investment instruments can be combined in a portfolio, but that they should be. Whether held in a single multi asset fund, or as part of a group of holdings, diversification should take place at the ‘active versus passive’ level as well as among individual securities, asset classes, regions, sectors or currencies.
This gives investors the benefit of broad access to markets, where smart decisions about regional and asset class exposure will be important, as well as the skill and experience of active investment managers, where reliable and consistent investment processes can add value over time.
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