Picking active vs passive investments

By Stephen Merlicek, Chief Investment Officer

In our last edition, we looked at the case for active versus passive management across different asset classes. The conclusion was that it depends on the evidence and the asset class. Some asset classes are active by their very nature (such as direct property, private equity and direct infrastructure), whilst other asset classes (such as equities) can be active or passive. At IOOF, with the help of our consultants, we review each asset class to see whether it is best to take an active or passive approach.

Australian equities

Starting first with Australian equities; here we take an active approach because the evidence over longer time periods is that active Australian equity managers can add value over the index – around 200 basis points per annum. This effect is more pronounced for small caps, microcaps and midcap managers.

In more recent times, it has been more difficult for active large cap Australian equity managers to add value over the index after taking into account active fees.  There has been much debate as to whether this is a cyclical or structural factor and as to whether the Australian equity market is becoming more like the US equity market.

At this stage, we believe the underperformance is due to cyclical factors and are staying with an active approach within Australian equities.

International equities

With respect to international equities, the story is more complicated. Within this space, evidence from our asset consultants and others is that the average international equities manager finds it difficult to outperform the benchmark.

Over 1, 5 and 7 years, according to Russell Investments, the passive benchmark (MSCI ACWI) is 1st or 2nd quartile, thus outperforming most managers. The exception to this is international small caps, mid caps, emerging markets and certain country/regional managers.

As a result of this and other evidence, at IOOF we have taken a core/satellite approach. By this, I mean that we have a large core or passive component to the portfolio (such as 50 per cent plus) and then we add a number of smaller active managers that have an ability to add value around the core – usually in the spaces indicated such as emerging markets and small caps.

The advantage of this approach is it is an efficient use of the risk budget – only paying active fees where managers are likely to add value, but at the same time keeping overall fees to a minimum.

A twist to this approach is that rather than using just a straight passive manager, in order to outperform the passive benchmark an enhanced passive approach is used – which is what we are doing at IOOF. The enhanced passive manager keeps most of the positive attributes of a passive manager (such as low fees or low tracking errors) but at the same time hits a bit of a sweet spot in terms of risk and return.

Enhanced passive managers aim to add around 100 basis points over index without the potential tracking error and fees of fully active managers.

Bonds

In terms of bonds, we do not take a passive approach despite the passive approach performing well in certain market conditions such as a bull market. The issue here is that the passive benchmark has its largest weight to the fiscally irresponsible countries (the countries that have the most debt have the highest weights).

Whilst this is not too much of an issue with respect to the US, due to its size and reserve currency status, for other countries it could be a real issue. Also, it would mean having the highest weight to the lowest yielding countries, such as the US and Japan.

At IOOF, whilst we use a passive benchmark for measurement purposes, we utilise active managers that have different country and sector weights and managers that have exposure to other forms of debt (such as corporate and high yield, which in this environment has higher yields and lower duration risk and no sovereign risk).  Also, many of these instruments are floating rate – thus avoiding inflation risk.

Direct property and alternatives

In terms of direct property and alternatives, an active approach is taken due to the nature of the underlying asset classes.

Conclusion

It should be remembered that despite the near-religious debate on the merits of active versus passive, passive is just another management style/tool in a multi-manager portfolio. Depending on the circumstances there can be a role for both active and passive management styles.