Why Active Management?

Investors have been debating the merits of active and passive investing for some time. While there are situations where passive management trackers can be beneficial for portfolios, in this article we look at the tools available to active managers and what we see as the benefits of this approach.

Market trackers and diversification

Market trackers seek to match underlying indices and, by definition, cannot be overweight or underweight any sector. This can result in a lack of diversification and high level of risk concentration. For example, nearly 50% of the constituent weights of both the FTSE 100 and S&P 500 are represented by just three sectors and each index's overall performance is therefore dominated by the fortunes of these. 

In addition, the most common type of index construction methodology is weighted by market capitalisation, i.e. the bigger a company, the larger its weighting in the index. This can create two problems:

• Excessive exposure to expensive assets, but underrepresentation of cheap assets
• Limited exposure to smaller companies that might prove key growth drivers

For example, the largest ten companies in the FTSE 100 represent 40.7% of its total market capitalisation. 

Downside protection

While passive funds are designed to match the performance of an underlying index, a key benefit of active management is the ability to protect against downside in falling markets. Active portfolio managers can reduce downside in a variety of ways. For example, they can hedge against specific investment risks or liquidate assets in anticipation of bouts of market weakness or volatility. In terms of hedging, index fund managers can protect portfolios against a wide range of risks, such as rising inflation, policy changes or declining liquidity. In this regard, it is important for actively managed portfolios to remain nimble to take advantage of developing market trends and events as and when they occur.

Although passive 60:40 funds have performed well over the past ten years, they might be less effective in the next ten, given current valuations within both fixed income and equity markets. This makes it important to consider alternative assets to facilitate diversification and reduce risk in order to outperform traditional markets. We note that in low-return environments this is particularly important, as fat tails present asymmetrically large risks relative to rewards. 

Passive vehicles do have a role to play

The use of index trackers can still be beneficial for investment portfolios. Indeed, we use passive investments where appropriate during portfolio construction. Their advantages include quick and cheap market access, as well as easy access to niche specialist markets, such as US smaller caps. 

Why active portfolio management now?

The last ten years have been good to passive investors. Both the equity and bond components have had circumstances in their favour. On the equity side, the US market has led the way, with its large tech companies (Facebook, Amazon, Netflix, Alphabet, Microsoft, Apple, etc.) dominating returns to such an extent that the top five companies in the S&P 500 now have a larger share of the index than ever before. It has been hard for active fund managers' performance to keep pace with passive investments in this environment, as they are wary of accepting the concentrated risks that these large companies represent. This long rally has largely been fuelled by cheap money from increasingly large stimulus packages, with the latest unprecedented interventions coming on the back of the pandemic. There are many reasons to think that this rally will not continue in perpetuity and its unwinding would likely create conditions more favourable for active investment management approaches than their passive counterparts.

At Waverton our equity component outperformed the global index benchmark last year despite being underweight the US and the big tech names that set the pace. This speaks to the positive stock selection of our stock pickers in most other geographies and sectors. If we see any signs of inflation in the short to medium term and economies continue to strengthen towards escape velocity, the outlook for the unloved areas of the market, such as energy and financials, will improve markedly. This will further the case for active fund management as the largest sectors, and companies, will be the underperformers.

The case for active investing in fixed income is clearer still. The passive investor has ridden the yield curve down from double digits to where we are today - zero rates and negative yield on gilts out to five years. This has been a great ride of relatively low risk coupled with excellent returns. If interest rates stay where they are for the foreseeable future investors will experience negative real returns of c.1.6% per annum for the next five years. Should rates rise at any time these losses will be magnified, having the ability to actively manage the duration of the portfolio in these periods is of paramount importance. Further, the corporate bond indices are comprised in such a way that those companies with the most debt make up the largest component of the market index and thus the largest investment from the passive investors. That does not seem a sensible way for risk averse fixed income investors to construct a portfolio.

UK Gilt 10 Year Yield - Returns projected over next five years at differing yield levels

As with equity funds, our fixed income component comfortably outperformed last year. Using a broad range of sovereign and corporate debt, backed up by sensible hedge fund strategies, we seek to build a portfolio that has less correlation with the private equity component and therefore adds value from a portfolio construction point of view and ultimately lowers the risk and enhances the return. by having a greater chance of outperforming passive strategies.

Conclusion

Given the start point for equities (record highs) and bonds (probably a bubble), we feel that it is of paramount importance to broadly diversified portfolios into a range of risk reducing and return seeking alternative asset classes. There are very few passive strategies that have any allocation to alternative investments and emerging markets, and this will be to their detriment.

Finally, the out-performance that we delivered last year in equities and bonds was further enhanced by the performance of our Protection Strategy. Institutional investors saw our hedging strategies allow for better long-term higher returns, better risk adjusted returns and a more pleasant journey vs passive short-term strategies. Once again, these tools and active management investment strategies are unavailable to the passive investor.