The merits of passive investing versus active is often debated, and given the challenging backdrop for markets last year, it’s no wonder this topic has come up again. Passive supporters argue that economic uncertainty and politics have made it notoriously difficult for stock pickers to succeed, while active managers argue it’s precisely these events that have created opportunities.
Whichever camp you sit in, there’s no right or wrong, but it’s important to understand the differences to make an informed decision.
Digging deeper
Passive is often seen as a ‘default option’, with lower fees and greater certainty on relative outcome. But passive investing still comes with choices.
‘Which benchmark would you like to track?’ ‘How closely does the fund track this benchmark?’ ‘Does the fund fully replicate the index?’ ‘How competitive are the fees?’ These are just some of the questions that investors can consider.
Active management needs far more detailed analysis. Active managers invest in a subset of companies within an index, so you could assume that active funds are less diversified than passive and therefore more volatile.
That’s why it’s important to dig deeper to identify a manager’s track record, what risk controls are in place and how important risk is to the manager, as well as how diversified a portfolio is (by industry or country, for example) to help mitigate such stock concentration risks.
In some cases, it might make sense to blend different active funds to offset their biases, sometimes resulting in greater diversification and lower volatility than index trackers.
Even an index with hundreds of companies can be concentrated by weight, with just a handful of the top 10 driving returns. US equities are dominated by the tech sector, while UK equities have a high concentration to the energy sector.
These are just two examples of a potential lack of diversification for passive investors. As of 30 December 2022, just five stocks in the FTSE 100 account for more than 30% of the index.
Go with the flow?
Active managers can navigate the diversification of risks, so we expect more from them to justify higher fees. It’s been difficult to outperform index trackers in recent years, with the majority of investor flows moving into passive instruments – particularly in the US.
Since 2010, the dividend contribution to the S&P 500’s total return averaged just 16%, compared to the historical average of 38%. You could argue that, in an era of close-to-zero interest rates across developed markets, these flows were the primary driver of returns. With tighter financial conditions beginning to impact ongoing flows and interest rates and dividends now at far higher levels, we could expect the dividend proportion of returns to shift back towards that historical average.
In this environment, you’d expect an active manager to add value, as the opportunity for stock picking becomes more attractive due to lower valuations. A passive manager has no scope to avoid exposure to companies at risk of weaker earnings or even insolvency.
US companies with stronger balance sheets have shown greater resilience towards the end of 2022, suggesting they’re better placed to weather the weaker economic environment of higher interest rates and costs.
Passive funds are regularly rebalanced, so if this trend continues, they’ll eventually reposition to a greater weighting to companies with strong fundamentals.
This ultimately means that over time, the demand for active and passive investments will ebb and flow, with strong ideological positions supporting either approach.
We recognise the need for both options and believe providing a breadth of choice in these areas or indeed a blend of both active and passive makes sense to fulfil investors’ end goals.
Colin Morris is an investment manager at Parmenion. The views expressed above should not be taken as investment advice.