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Active or passive: the right strategy for your firm and your clients

In an age where IFAs increasingly look to partner with online investment management services to combat robo creep, the question remains, active or passive – which strategy is right for your firm and most importantly, your clients? James Penny, senior investment manager at TAM Asset Management, gives Adviser-Hub the low-down. 

 

Research suggests passive strategy works best for most investors. How would you respond to that claim?

It’s a question of suitability. If a client wants 100% exposure to a single market with little headline cost and no regard for the management of relative risk, then passive investing might be appropriate. 

I would say that active discretionary fund management has been a stalwart of capital markets since investing began, so to argue that this approach now plays second fiddle to passive investing would be an argument many would contend with. I think the environment we have found ourselves in as investors has, for over a decade, lent itself to passive, low touch, low cost investing and this has served to overshadow the art of running an active, risk adjusted portfolio for clients. 

When we hit a true bout of volatility like we did in 2008, perhaps the research might indicate that investors are more willing to engage with active management over passives once again.  

 

What are the downsides of passive investing? 

Much in the same way an ETF gives you unfettered exposure to one theme or market, many passive portfolios tend to offer the same exposure because they all own the same set of indices. This can lead to an element of similarity in terms of what’s on offer at different providers. 

It’s true that passives are becoming more versatile. That’s not to say they’re more complicated – just evolving as an asset class to meet the growing demand for more diverse products. The fact remains that a passive product will give you pure exposure to a specific subset of investments without the ability to include or exclude certain elements of it. With the addition of sector specific ETFs and smart Beta ETFs, IFAs are starting to construct portfolios from more niche passive instruments; this in itself could be considered another form of active management.   

 

What about active investment? 

Risk remains one of the main sticking points when it comes to managing client wealth. Active management is still the most effective route to creating a risk adjusted portfolio for a client – retaining the attractive, yet often overlooked, ability to dial the risk up and down within the portfolio to take advantage of short-to-medium term market movements. 

Many advantages of active management centre around providing a client with a more versatile and diversified investment solution. Whilst hedging can be attained in a passive instrument, it lacks the sophistication of the hedging capabilities within an actively managed portfolio – as well as the more holistic services which an active manager can provide such as CGT tax management, finding strategic entry points into the market with client capital, reallocating profits from outperforming investments, and moving capital into value areas of the market to capture the potential for a positive correction. 

Active management has defensive capabilities that also prove useful: being able to move into uncorrelated investments to protect capital in a downturn is a vital ability in a bull market. With many signs suggesting a possible recession on the horizon, this should be something investors consider when thinking about the long-term survival of their past decade’s gains. 

 

Isn’t passive less risky and cheaper – and therefore an easier sell for an IFA?

It’s cheaper to own a traditional passive compared to an active fund invested into the same market. 

With respect to risk, this works both ways. Managers can ramp up risk levels to above the market norm if using a high return strategy, or dial down the risk to well below that of the index if they want to defend capital. Passives can’t do this: investors have to own the entire market, warts and all. ‘Buying the market’ in this way negates the need to really discuss risk, because versus a specific index it becomes a moot point. 

However, as investment managers know, clients do usually have risk perceptions, and these can be either higher or lower risk than what a passive investment can offer. Tailoring an active strategy to this risk tolerance should be both straightforward and rewarding for the client’s investment expectations.

 

Why do robo-advisory platforms typically follow a passive strategy? Is it a lack of education?  

Passive investing has always been the low-touch, broad-exposure approach to gaining access to a particular market. It requires very little bottom-up research compared to active fund management and is therefore more cost-effective.  

A robo-investor will have a smaller allocation of investable capital to commit to the market – so a basket of passive investments would allow the client to receive a wide ranging, often global portfolio, where a more selective active manager would struggle to provide for the low cost that clients desire. The objectives of passive investing are also easier to understand from the perspective of a client who is new to investing – and clients who are new to investing are typical for the robo market.  

Passives are here to stay – it’s a simple fact. Many DIMs have an exclusively or largely passive-focused offering, and some (like TAM) offer them as a complement to active portfolios. What active managers must decide is how to utilise them within an active strategy.  

 

What should an IFA consider when partnering with an online investment manager from an investment strategy perspective? 

Think about what your clients are after and think about what investment approach is going to work for their capital over the coming years. Passive investing is great in a bull market that’s over ten years long – like ours is today. Markets have gone up year-on-year, and passives have risen in value. Investors haven’t paid much for the pleasure. 

Now, signs indicate that we are getting ever closer to a recession, and you probably don’t want to own a passive instrument which simply drops in line with the market. After all, a passive investment IS the market.

Clients should partner with a discretionary investment manager that offers a diverse range of investment solutions to meet a diverse market. Managers focussing on ‘capital preservation’ will be key in this market. It’s all well and good making money when markets are shooting up; the trick is not giving it all back again when markets head south. 

IFAs have very close relationships with their clients and this often involves a holistic approach to managing a client’s entire capital allocation. Investing the client’s liquid capital into markets should be first and foremost managed by industry experts whose sole expertise is portfolio management. This leaves IFAs much more time to focus on optimising the other elements of their clients’ estates; it also reassures clients that their specific investment goals are being looked after by professionals who are not only driven by profit generation, but also by profit preservation. A mission statement that passive investing would be hard pressed to achieve even with the lower fees. 

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