Based on some of the feedback to my pension review piece last week I thought I’d expand a bit on my belief in active funds and how they can be used to enhance a portfolio, even if the manager fails to beat the market and despite the additional drag on performance from higher fees.
This is quite controversial. There is plenty of research that shows over the long-term most fund managers fail to outperform the market, so it logically follows therefore that it isn’t worth paying fund managers for market returns – ETFs and trackers offer the same performance at a lower cost.
Passive funds aren’t without their problems either, mind, something I’ll probably come back to in another article.
What all of the research into the cost/benefit profile of active funds has failed to pick up on however, is that the active management process has the welcome side effect of lowering a fund's correlation to its asset class.
I’ll admit that there are very few normal people who would see a marginal change in correlation as something to celebrate, and probably few who will pay it any attention at all.
This is a mistake. The correlation of investments – how the change in value of each one is related to others – has provided the core of portfolio theory for almost a century and exploitation of this relationship is probably the biggest advantage professional and institutional investors have over the average DIY portfolio manager.
The term diversification is bandied about all over the place in the investment industry and is often used to mean a wide range of things.
At heart the principle can be summed up as “not having all your eggs in one basket”. Investing in multiple countries rather than just one protects you from the risk of an individual nation going into meltdown; think Europe over Greece.
Investing in different sectors can insure against economic factors sinking a single industry: think FTSE over banks and so on. This is all quite obvious, but gets overlooked when it comes to funds.
By just investing in passive funds you are only exposed to a single strategy – index tracking. Within the universe of active funds there are hundreds of strategies for every asset class.
There are a near infinite number of opinions and outlooks, even discrepancies in what time of day the fund’s broker places trades all combine to make sure that even funds ostensibly investing in the same things will behave differently.
These differences can be used to increase diversification: that is to say they will help you find investments that rise when others are falling so that the overall effect is a portfolio that is far more stable than its constituents.
Imagine a moderately cautious investor who had identified the need for a 20 per cent exposure to UK equities. A likely outcome would be a cautiously minded, defensive fund, possibly in the UK Equity Income sector that offered access to the asset class and fitted the risk profile of the investor.
But a better solution exists. Within the spectrum of UK equity funds available there will be a combination that provides a superior solution.
Assume there are two alternatives: a fund with an aggressively minded fund manager with a bullish outlook on the economy and who believes in the growth prospects of the technology sector; and a fund that relies on pure stock picking to identify undervalued companies and has a bias towards only the most stable and financially secure firms.
These two funds invest in the same asset class but will behave differently, the conditions for one to excel are different to the optimal conditions for the other. The same principles of diversification apply: the combined returns are available for much less risk than average.
If we expand this principle across all asset classes, it is possible to use the active element of funds to add further diversification benefits and obtain the same asset class exposure within a portfolio for a much lower level of risk than expected.
Alternatively, the same level of risk can be achieved while having greater exposure to risky, higher-returning assets.
An example of how this works in the real world is seen below: a portfolio following the same asset-allocation strategy using active funds is able to have a much lower risk profile than the same strategy implemented with index tracking funds over an 18-month period.
Performance of portfolios over 18-months
Source: FE Analytics
This chart shows that the active fund strategy has a lower and more stable amount of risk, because changes in economic and market conditions are easily coped with by having a wide range of active strategies.
This is the reasoning for my commitment to active funds in my recent pension review. In isolation there are trackers that offer better returns than at least half of the equivalent actively managed options and cost much less to run.
Careful selection, however, can make your portfolio far more than the sum of its parts. Using active funds to lower the risk in a portfolio makes it worth the extra fee alone; any outperformance is a bonus.
Still, while personally I’m firmly in the active management camp, I’ll use next week’s piece to go through my analysis process for passive funds and what I look for in a good tracker.