Whilst active management still plays a crucial role in portfolios, there are some instances where a passive approach can be preferable, according to Momentum Global Investment Management’s James Klempster.
Klempster (pictured), Momentum’s investment director and manager of the £18.8m MI Momentum Focus 5 fund, uses a combination of active and passive strategies in the multi-manager portfolio.
“We do believe fundamentally in active management, we believe that markets are imperfectly priced and therefore there is scope for active managers to add value over time if they’re good,” he said. 
“But where we don’t see the need to use active managers, we will use various passive vehicles.”
There are four reasons why he tends to use passive vehicles into portfolios, and the first was simply down to cost.
He said: “If you don’t think that the additional alpha from managers in a particular market is that attractive, then that’s a great place to save a bit of cost, and all those cost savings, of course, get passed on to investors.”
The second reason he would use a passive vehicle over an active one is “when we are renting an asset class rather than buying it”.
He explained: “Some opportunities get presented to us, they look almost like a second look like a secular valuation opportunity, a really long-term valuation dislocation.”
Klempster said in that sort of environment, it makes sense to use an active manager or a basket of active managers because “you’re likely to have enough time for not only the asset class mispricing to reassert itself, but also enough time for manager alpha to come out through the wash”.
In the event that the asset allocation opportunity is not ‘long’ enough, in other words, when you are ‘renting’ the asset class where it might pull back quickly and retrace, it “doesn’t necessarily give enough time for the manager outfit to come to fruition”, Klempster said.
“So, what you end up risking there is that you get your asset allocations absolutely right, but the vagaries of manager alpha is such that they actually underperform and undo some of that hard work that we put in,” he explained.
In those cases, passive vehicles are his preferred choice.
The third reason is down to the efficiency of certain financial markets.
In US, for example, despite having very efficient capital markets and widely popular index-tracking strategies, Klempster believes there are still opportunities for active manager alpha.
He said: “We don't necessarily subscribe to the view that the US stock market is too efficient to determine against active management, particularly if you start looking on a stylistic basis or on a sectoral basis, or even a size basis.
“Maybe if you’re [investing] across the whole index it’s tricky, but we wouldn’t necessarily take the view that investing in the US requires you to go passive.
“But we would say [for] something like government bonds, for example, it’s very hard to see a big benefit to being active if you’re just going sort of long-only government bonds for the purpose of portfolio insurance.”
Government bonds for portfolio insurance is an asset class where he would take it a step further and buy the asset class directly rather than investing in a passive vehicle.
Indeed, the MI Momentum Focus 5 fund, the largest strategy that Klempster manages, has direct exposure to US Treasury inflation-protected securities (TIPS), its third largest position.
The fourth and final reason he would consider a passive approach is down to index composition.
He said: “Let’s think about why you might buy an aggregate bond strategy, so govies [government bonds], a bit of investment grade, and some MBS [mortgage-backed securities] in the mix.
“That’s there as a diversifying asset, it’s your portfolio insurance, and these days in particular given the way yields are, that essentially is an event risk hedge.
“Yet if you think about what active managers tend to do in that space, active managers tend to lean underweight duration, they tend to lean overweight credit as ways to add value in that particular market.
“But the two things you don’t want to be when you have an event that spooks the equity market – and therefore these diversifying assets that should help you – is underweight duration, overweight credit.”
So, in terms of getting an optimal exposure to investment grade or aggregate bonds, he believes it makes more sense to invest passively than it does to go for an extreme active strategy.
Yet, despite these four reasons, Klempster said certain markets can imperfectly capture long-term information, and that there is scope for active management in any market that demonstrates a propensity to being mispriced or have elements of mispricing.
He explained: “Markets can be mispriced over the short term, but even more meaningfully over the long run.
“When you look at the spread between value stocks and growth stocks, at the moment and how they perform, to me that looks like an opportunity for active managers to exploit.”
“As the last six months have shown, anybody who was biased towards growth, or overweight the mega-cap tech names, would have had an extraordinary run.”
But he argued that this dispersion just shows that “if you can get somebody who’s good at stock selection within their particular niche, there’s some real value to be added over the long run”.
Performance of fund vs sector & benchmark over 5yrs
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Source: FE Analytics
Over the last five years, MI Momentum Focus 5 has delivered a total return of 23.8 per cent versus 26.1 per cent from the UK CPI + 3 per cent benchmark and 41.44 per cent from the average peer in the IA Flexible Investment sector. It has an ongoing charges figure (OCF) of 1.31 per cent.