While many advisers will recommend a blend of investment styles for a portfolio, knowing which to use an active or a passive vehicle can be difficult for investors. Some sectors may be more suited to passive investment strategies while others can benefit from a more active management approach.
The difference between choosing an active and a passive strategy can mean more than just the cost of the fund, it can often make the difference in terms of performance.
Mike Deverell, partner & investment manager at Equilibrium AM, says it has spent time identifying the sectors best suited to the different strategies to see which funds can add value.
“Some years ago we carried out detailed research on a sector by sector basis,” he explained. “This showed that in some sectors, like in Europe, Japan or in UK smaller companies, there was compelling evidence that active management can add value.”
“In others, such as the US, very few funds (if any) seem to outperform. As a result, we’ve invested largely in a tracker for US exposure.”
“In other areas it is less clear cut, for example in UK All Companies, and so we have often used both approaches.”
Ben Seager-Scott, director of investment strategy and research at Tilney BestInvest, said that it does not have a preference for active or passive funds.
“We look at both areas, and we're agnostic between active and passive,” he said. “I think it is fair to say there are areas that do lend themselves better to using a passive route, and those that are distinctly not well suited.”
Having previously looked at the areas where passives may be the preferred instrument, FE Trustnet looks at the asset classes the experts prefer to use active managers in.
UK Smaller Companies
One of the best areas where active managers can add value to your portfolio is at the bottom end of the market spectrum, according to Equilibrium’s Deverell.
“I think the most compelling one is [UK] Smaller Companies,” he explained, adding that stocks at the lower end of the market cap spectrum may not have the same level of research and analyst coverage as larger companies.
Deverell noted that many smaller companies are researched by just one or two companies, giving an active manager more opportunity to find a competitive advantage.
He said: “It is a less efficient market and actually we think that not only do you need to active with smaller companies generally - the more experienced the fund manager the better because a lot of it is about knowing the people.”
“We like managers like Gervais Williams at Miton or Giles Hargreaves at Marlborough who have been around for a long time and know these companies and management teams inside out.”
Performance of managers over 3yrs
Source: FE Analytics
As the above graph shows, both managers’ small-cap-focused funds have significantly outperformed the sector and Numis Smaller Companies index over the past three years.
Hargreaves’ £1bn Marlborough Special Situations fund has returned 39.21 per cent over the three-year period, while Williams’ Miton UK Smaller Companies has risen 29.68 per cent.
Targeted Absolute Return
Tilney BestInvest’s Ben Seager-Scott says alternative asset classes are more likely to benefit from active managers as liquidity is lower and information less readily available.
“These are really areas that much less suited to passives,” he said. “Absolute return funds really lack passive options at the moment, and physical property is still really beyond the reach of passive at the moment, beyond some interesting developments from the likes of iShares.”
Absolute return funds have been growing in popularity since the financial crisis of 2008. The sector has been controversial, with some arguing investment targets of provide anything above cash can often leave minimal returns at best once charges are taken into account.
Indeed, the average fund within the IA Targeted Absolute Return sector has a clean ongoing charges figure of 1.1 per cent while the average OCF in the IA UK All Companies sector is 0.9 per cent.
As the below graph shows, while the sector average has managed to smooth out the last three years for investors, with very low volatility exhibited, it has underperformed the FTSE All Share by 9.76 per cent.
Performance of indices over 3yrs
Source: FE Analytics
Yet, the IA Targeted Absolute Return sector has been the best-selling retail peer group for seven months of the past 10 and was the most bought sector in 2015, according to data from the Investment Association.
Emerging Market Debt
The third area active strategies tend to outperform is emerging market debt. Jim Barrineau, co-head of emerging market debt relative return at Schroders, says the asset class is “the worst” for passive investment strategies.
“If you want to do large cap equities with ETFs knock yourself out, but ETFs for emerging market debt are the worst way to play this asset class,” he said.
This contrasts with the emerging market equities sector, an area where passive strategies have been extremely successful in recent years.
Equilibrium’s Deverell said: “I think one of the things is that we did have this emerging market bull rally for a number of years where in a sense all the emerging markets were going up or down.”
“Huge Chinese growth would then feed in to all other emerging markets that would trade with them and so that in a bull market it is pretty hard for any active fund to do well.”
Schroders fund manager Barrineau says passive investment is not suited to emerging market debt, however, noting some of the challenges for performance.
“The fee structure is about as high as it is for active managers; [passive fund] indices only cover a small part of the opportunity set and they have a structural underperformance relative to their benchmark because trading costs in this asset class are so high,” he added.
“Over the last five years there has been about 500 basis points of structural underperformance so they don’t replicate their indexes they underperform their indexes – so it’s a terrible way to invest in emerging market debt.”
Performance of indices over 5yrs
Source: FE Analytics
As the above graph shows, the average active fund in the IA Global Emerging Markets sector has outperformed the average ETF by 13.66 percentage points.
In fact, over both shorter (one, three and six months) and longer timeframes (one, three and five years) the average active manager has come out on top, with the gap at its widest over three years (17.41 percentage points).