The debate about passive funds is often framed in terms of an "either/or" choice – a debate between those who think that active management is over-priced and ineffective and those who insist on the superior returns available from picking the right managers. However, Laird says this does not reflect how most investors use passive funds.
"The traditional view that some investors are active and some passive doesn’t hold true anymore from what we see," he explained.
"How investors use them depends on their aims rather than on whether they are active or passive investors."
Laird revealed to FE Trustnet the four main strategies he sees investors using to integrate passive funds into their holdings.
Build a core of passives
"Some investors build a broad base for their portfolio with passives and then pick active funds in areas they want to add more risk, tactically weighting their portfolio to managers who have been shown to provide good returns," Laird said.
In December, FE Trustnet research showed that a basket of passive funds covering the major markets beat all but three multi-manager funds over the past three years.
Performance of portfolio over 3yrs
Source: FE Analytics
Multi-manager funds have different strategies and objectives, but they tend to appeal to investors with less money to invest and less experience, but who still want to get diversification without having to buy lots of different funds.
For these investors this first approach may have the same effect and at a much lower cost.
Passive funds typically charge less than 0.5 per cent in fees (in terms of total expense ratio), while the average figure for retail funds in the four mixed investment sectors is 1.33 per cent, according to data from FE Analytics.
Double up
"Doubling up is a strategy that may be interesting to clients, because by compounding active and passive investments from the same sector you are receiving a lower overall charge, and whereas you do not have the potential for the bigger gains, you are arguably getting the best of both worlds," Laird said.
This strategy provides a cheap way to lessen single-manager risk – the dependence on a single manager to continue a track record of good performance.
However, it also means that if the index does badly and the chosen active fund manages to counteract this through good positioning, investors will not be able to fully benefit from this as part of the portfolio will be unprotected.
High-growth sectors tend to be more volatile, while their best-performing funds tend to be significantly less volatile.
In the Asia Pacific region, for example, the annualised volatility on the MSCI AC Asia Pacific ex Japan index is 23.03 per cent over the past five years.
However, the three First State Asia Pacific funds in the sector have a volatility of less than 18 per cent over that time, meaning that an investor who had diversified their holding of these funds with a passive would have suffered more of the market volatility.
Performance of funds vs index over 5yrs
Source: FE Analytics
Unfortunately, First State has been attempting to slow inflows into its Asia Pacific funds, which are not only top-performers in terms of volatility but also in terms of returns.
Pick sectors
A better-known strategy is to use passive managers for markets where good active management is currently unavailable.
"There are areas that active managers have struggled to outperform, like the US for example," said Laird. "In these sectors it makes sense to by-pass active management in favour of passives."
"However, it is also the case that in emerging markets, the best-performing active funds are slowing down the flows into their funds."
First State and Aberdeen have gone down this route recently with their emerging markets funds; last week FE Trustnet reported that Aberdeen Emerging Markets is to charge 2 per cent on new investments to deter inflows.
"Aberdeen Emerging Markets is an example," Laird continued. "Traditionally emerging markets have been a good place for active management, because there has not been as much research out there."
"We found the active managers who are left and haven’t slowed flows have not managed to perform as well."
Use passives tactically
A variant of this approach is used by FE Alpha Manager David Coombs, head of multi-manager at Rathbones.
Coombs told FE Trustnet earlier this month that he had recently bought the iShares MSCI Asia Pacific ex Japan passive fund to increase his exposure to the region.
He explained that he was using the passive while he waited to complete his research on the best fund to use in the area.
This approach – dipping in and out of passives to add exposure to markets and regions the investor expects to do well – may appeal to more active investors, who are happy to track how their portfolios are performing and make regular adjustments.
It does require more time, however, and means that investors are backing their own judgment rather than trusting the expertise of an active manager or the providential course of the underlying index.