With a huge growth of assets in Exchange Traded Funds (ETF’s), we ask, are these more modern products suitable within multi-asset portfolios? Below is a guide to help investors gain a better picture. As every investor’s situation is different we encourage you to discuss this with your Advisor.

Active: The manager makes specific investments with the goal of outperforming a benchmark index.

Passive: Investments that do not try to create a return in excess of a benchmark. They aim to replicate the benchmark’s performance at a lower cost.

Appropriate asset allocation is still needed with both active and passive solutions. Whether asset allocation is through the choice of benchmarks or through active asset class positioning, such decisions dominate performance.

Active management is more likely to deliver outperformance in less efficient assets like small cap equity. Equally, outperformance is difficult in more efficient assets like government bonds.

Passive solutions work better in mainstream asset classes. In more niche areas passive solutions can be expensive or have hidden drawbacks. For example a government bond index can be replicated easily but not so in commodities. Passive solutions can differ enormously in terms of fees, tax, liquidity and risk.

. Many multi-asset fund managers using both active and passive funds focus much attention on deciding which asset classes they want to be invested in. The next stage is to consider if there are opportunities within each asset class. Does a manager prefer small cap or large cap equity, value or growth?  High quality or distressed credit?  If these cases, passive is not impossible, but trickier and sometimes more costly. 

It is also partly an implementation question. At times the most efficient way might be to use passive strategies over active or vice versa.The decision tree starts with asset allocation. Whether you are in an active or passive equity fund, if markets fall by 20% you are likely to suffer material losses. 

Passive is often considered low cost.  How does active and passive compare? Largely, passive is cheaper than active but is not always the case.  For mainstream equities and bonds, passive is usually cheaper. In the credit markets, like high yield and loans, passive can often be more expensive. (bps – basis points)

Source: Momentum Global Investment Management, November 2011

Vulnerability to index arbitrage: hedge funds arbitraging the rebalancing of an index like the FTSE is at the cost of passive strategies. A strict tracker is forced to buy stocks after they have appreciated and sell others after they have fallen.

Roll costs: in some commodity markets, futures strategies are forced to roll holdings month to month to avoid taking delivery of the physical good. This can be a headwind for passive strategies.

Trading costs and bid/offer spreads: This is an opaque area and does not always favour passive. 

Passive management

Ease of execution: a quick and simple solution.

Relative certainty of performance: usually get the index performance less fees and other costs.

Active management

Possibility of outperformance: more likely in some areas than others (e.g. value/momentum) or more inefficient areas (e.g. small cap).

Passive solutions tend to be best for temporary holdings in large and liquid equity markets, government bond markets and gold.  With longer holding periods or certain other markets, active management might offer out-performance. Generally, you would use active management where the odds of outperformance are in your favour.

  Efficiency is key to whether active management is likely to deliver results -

  Active management is tough in efficient markets

 Active management is more likely to succeed in less efficient markets

 As outperformance is not guaranteed it is prudent to make fund selections from a portfolio of managers.

A final point on passive investing: There are a multitude of passive strategies, Trackers and ETFs being the most common.  It is important for investors to properly understand each solution.

Fees: fees for passive solutions differ. This may depend on how much you are investing and your negotiating skills.  For the retail investor, equity ETFs can be expensive relative to tracker funds. Cost must always be compared on a like for like basis i.e. for ETFs and passive funds, remember to take into account bid/offer spreads as well as the annual management cost and total expense ratio.

Tax implications: does your ETF suffer withholdings tax?  What is the impact?  For a fixed interest asset, this can be a substantial part of the overall return.

Liquidity: how liquid is the structure? 

Concentration risk: To maintain daily liquidity, the ETF tends to hold the most liquid instruments. The first US high yield ETF only held 20 securities. That opens up more ‘stock specific’ risk than a mutual fund.  

Security: a key point for commodity ETF’s like gold.  Does the ETF physically own the underlying asset, or does it just have an ‘IOU’ from a bank which is worthless if the bank goes bust?

Whether investors go active or passive they still need to take a number of key investment decisions. In terms of outperformance, it is possible to find asset classes where active management has provided a sustainable advantage. Yet investors are far more likely to benefit from these rewards if they focus efforts on areas which are less efficient and where managers stand a better chance of outperformance.

 In the right circumstances passive solutions can be a very useful tool. They offer a low cost and easy alternative for many investment decisions. While for most mainstream markets, investors can sometimes get away with this approach, they need to fully understand what they are buying.