Edition: Sep - Nov 2014
The best form of active is passive
So argues De Wet van der Spuy, divisional director (product) at Liberty Corporate.
Van der Spuy...intelligent investing
When the first unit trust was launched in the UK in 1931, it comprised 24 leading companies. This did not change for the 20-year fixed lifespan of the fund. Since then, things have moved on considerably. However, debate continues to rage on whether to choose active management or passive tracking.
Liberty Corporate, through our philosophy of intelligent investing, conducts regular research into the merits of the two approaches. What do we believe is the best approach? The approach that ensures that you, as trustee, meet your obligations and offer the most appropriate solution for the majority of your members. This could be a passive investment approach or an active approach, or more likely it is the right blend of both.
Many investors see passive investing as simply putting money into a tracker and reaping the returns of the market – positive or negative. However, there is an entire toolkit available to support your passive strategy, including tactical smoothing, asset allocation, protection overlays, and life staging.
In this article, we draw on our insights into intelligent investing to highlight important concepts and considerations when choosing the best investment approach.
Growth in passive management
Recent studies have shown an increase in assets flowing to passive strategies in the US over the past four years. Although the equity assets held in active strategies are higher, the growth in passively-managed equity has been more than double that of actively managed equity.
Driving the choice
Legislation stipulates that retirement funds must offer a default investment option to members. It must be appropriate for the majority of the fund’s members. In trying to determine the best solution, trustees must consider:
Cost – trustees have the responsibility of finding a solution where costs do not erode investment returns.
Risk – all manner of risks need to be considered; from investment risk to manager underperformance, to key-man reliance – what would the impact be if a star manager leaves the fund?
Return – what solution can give members access to markets at low cost, while reducing many of the risks?
The most appropriate answers to these questions always have to take into account the trustees’ specific objectives and circumstances. Passive strategies can be a valuable part of the answers.
Strategic asset allocation
The influential study by Beebower et al titled, “Determinants of Portfolio Performance”, found that strategic asset allocation is by far the biggest determinant of variation in portfolio performance. Up to 93% of the variability in performance is determined by the strategic asset allocation. What this means for trustees is that time spent on the fund’s long-term investment strategy is far more productive and effective than focusing on individual manager performance and monitoring.
Is it all or nothing?
Passive investing is not an “all or nothing” approach. At its core, Liberty Corporate’s intelligent investing combines passive investments with selecting high-conviction managers to generate active returns. By doing this, you meet your obligations as trustee -- to offer a default investment option that is appropriate for the majority of the fund’s members -- while enhancing returns through select active managers, and ensuring lower costs to members.
Once you have achieved this, the next step can be to combine a range of innovative solutions onto your passive (core) and active (satellite) approaches, such as smoothing, protection, life staging, risk management and tactical asset allocation.
With the right mix of hedging techniques and smoothing, a passive approach can offer cost-effective risk management to members. Tactical asset allocation ensures that the best blend of asset classes is chosen, giving the portfolio diversified exposure, thereby reducing risk and maximising growth potential.
Life staging is an important means of providing appropriate investment options to cater for members' changing risk tolerance as they approach retirement.
Timeframe changes everything
One of the most important criteria for deciding how much of the fund to allocate to passive or active styles, is to look at your timeframe. If you are investing for the long term, a high allocation to a passive approach should generate returns in line with the market, with minimal investment costs. The return that you will be generating is twofold; firstly, from the overall performance of the market over the long term; secondly, from the compounding effect of cost savings.
Over shorter periods, active management can generate higher returns based on market analysis and stock selection, and act as a counterbalance to some of the idiosyncrasies of our market, such as rand exposure and a large resource sector. This is why its role as the active satellite portion of a fund’s strategic asset allocation is well suited.
Responsibility is crucial
When considering your fund’s strategic asset allocation, it is not a choice between passive or active investing, but rather a question of whether you are meeting your responsibility as a trustee by offering members appropriate investment choice, cost-effectively, over the long term.