Fund investment: active, passive or blend

Investments in a discretionary portfolio or fund can be either active or passive or a blend of the two.

In the case of active fund management, a manager is employed to outperform a benchmark – either an index, the FTSE 100 for example, or another target, such as the rate of inflation – by an agreed percentage. This is usually done through researching securities, deciding when to buy and sell them, by selecting their weightings in the portfolio and then monitoring the portfolio on an ongoing basis.

Passive offerings, meanwhile, attempt to follow exactly, in other words ‘track’, an index rather than outperform it.

Passive investing

The type of vehicle for passive investments will normally be either an exchange traded fund (ETF) or a more traditional open-ended investment company (OEIC), unit trust or, occasionally, an investment trust.

ETFs are listed on an exchange and can be traded and settled at any time during the trading day, just like shares.

The more traditional funds can only be traded at one or two points during the trading day. Importantly though, they do fall under the auspices of the Financial Services Compensation Scheme (FSCS) whereas ETFs do not.

There are three main methods of passive investing:

• Full Replication, where each security in the index is bought in the same proportion as in the target index (with modification of security holdings happening only when companies periodically enter or leave this target index)
• Partial Replication, where only the largest and most liquid securities are purchased
• Synthetic, where derivatives or other financial instruments are used, for example a provider enters into a swap agreement with an investment bank, under which the latter promises to deliver the performance of the underlying index in exchange for a fee

With Synthetics there is a risk that the counterparty, the investment bank in this example, defaults and is therefore unable to deliver the agreed performance. In the cases of Full and Partial Replication, where the securities are actually owned, there is the risk that if these securities are lent out (to enhance investment returns/lower costs) then they may not be returned to the manager.

Active investing

With active investments the investor needs to believe, firstly, that there are managers out there who can deliver outperformance, or ‘alpha’, over a sustained period of time and, secondly, that these managers can be identified in advance. In these times of lower investment returns, a few extra percent of return each year can make quite a bit of difference over time.

There are risks, though, that these ‘skilful’ managers don’t deliver any extra performance or, worse still, underperform. Plus, active management is generally more expensive compared to passive management.

Blend

There can of course be both active and passive investments in a discretionary portfolio/fund. For example, many people believe that US equity markets are very efficient and already highly researched by fund managers and analysts. Therefore, passive management might be best for the US equity part of any portfolio, while emerging markets are less efficient and researched, offering more scope for active management in that area.

It all comes down to weighting

It is worth noting that whether the investments are active, passive or a blend of the two, the allocation between the different investments will always be active. So even if all the individual investments in the discretionary portfolio or fund are passive, the manager must still decide, either subjectively or using some model, what the weighting is for each within the total portfolio.

Enhanced index

In recent years the market has seen growth in enhanced index (also known as smart beta) products. These also track a market index but with certain modifications in place (e.g. the inclusion/exclusion of some securities using a mechanical rule or the use of intelligent trading algorithms) in order to try and generate modest excess returns.