A discussion, not a debate: active and passive investing

Both approaches offer compelling advantages, but the key is understanding the underlying exposures to risk and opportunity in the context of your investment goals.

The relative merits of ‘active’ and ‘passive’ investing are a well-worn debate in the industry. Would you prefer a fund manager to actively manage your money? Or perhaps you’d prefer your investments to track the market? Either way, understanding the difference between active and passive fund management is important, as each brings different merits and relative costs.

What is the difference between active and passive investing?

The job of an active fund manager is to buy and sell investments. This involves consciously making decisions based on their view of the investment’s prospects, choosing where to invest – and which risks to take – with the aim of delivering a performance that beats the fund’s stated benchmark.

Passive fund managers don’t have to pick which investments to hold in their funds, and your return depends almost entirely on the performance of the index being tracked. Passive investing involves tracking a selected market index and, by doing so, delivering a similar level of performance to that market. The fund manager replicates the movement of the market they’re tracking rather than trying to outperform it. Typically, management fees will be lower for passive investments, which are promoted as low-cost ways of investing.

Performance potential

Managing investments usually involves a balancing act between delivering an attractive level of return while taking an appropriate level of risk and at a reasonable cost.

When it comes to multi-asset portfolios (which can include a variety of different asset types, such as shares or bonds, property, cash or even gold), there are three main approaches to gaining investment exposure: selecting active underlying investments, passive underlying investments, or a mixture of both. The approach will impact the investment decisions and the end outcome. Understanding how the risks and opportunities might differ between active and passive investing – specifically, performance potential, risk control and the available investment universe is important.

Active managers can seek out those investments in which they see the most value, aiming to outperform the market – but of course, there are no guarantees. There is the potential to both outperform and underperform after fees. The success of active managers is driven by their investment decision-making. It is important to thoroughly understand what drives this – looking at, for example, what they invest in and why, their investment style, their risk characteristics and performance in different market conditions.

Passive investments aim to track the performance of a chosen index by replicating it rather than outperforming it. There are different ways of replicating, and while management charges are usually low, they are still incurred. Again, careful analysis of the investment is essential as this combination of factors means the actual performance of the passive investment may differ slightly from that of the index.

Intended and unintended exposures

Regardless of whether an active or passive investment is used to gain market exposure, it is important to be aware of the size of underlying allocations (what the end investments are).

In an active investment, the manager makes a conscious decision to allocate to a particular investment area. The manager will likely consider the size of this allocation in relation to the rest of the investments, as well as the level of risk they wish to take.

Meanwhile, the concentration levels of passive investment exposure are purely driven by the composition of the underlying index being tracked. There are a huge number of passive investment products available, but regardless of which one you choose, it’s important to understand the underlying allocations and how they may change over time as the index changes. If an investor does not consider how the composition of an index might change, they could end up with allocations that are not in keeping with their wider investment aims.  

Understanding the underlying risk exposure for fixed income investing is equally important. For example, bonds’ sensitivity to changes in interest rates can vary, as can the risk of default on bonds. Active investments can alter their exposures in these respects, but passive investments cannot.

Concentrated exposure or taking certain risks isn’t necessarily a bad thing. Still, it’s important to understand what risks are being taken, whether through an active decision or by tracking a certain index.

Accessing an expanded opportunity set

Another potential benefit of active investments is that they can increase the range of opportunities on offer.

Beyond equities and traditional fixed income, the wider investment universe provides opportunities for multi-asset portfolio managers to access more sources of potential growth, income and diversification. While some passive options are available to gain exposure to these, certain areas can only be accessed using active investments as no suitable passive investments exist.

Attractive investment opportunities can be found within real estate, infrastructure, music royalties, renewable power generation, structured products, energy storage, alternative income, healthcare royalties and other specialist strategies.

While they may present attractive opportunities in terms of alternative sources of growth, income or diversification, these more unusual investments do have specific risks, and therefore, an experienced management team with the ability to conduct rigorous due diligence and actively manage exposures is essential.

Bringing it all together

When it comes to active and passive investment strategies, it isn’t the case that one size fits all. The key is understanding the risks and opportunities associated with each in the context of overall portfolio objectives.

At Brooks Macdonald, we have both strength and depth of investment resources, and apply substantial rigour to the selection of all underlying investments used in the construction of our portfolios. Taking a hands-on role in overall portfolio management allows us to take advantage of the investment opportunities that the investment world presents and manage any risks as they arise.

In a challenging market environment, having the flexibility to seek out and allocate to sources of potential growth and income from across the broadest possible investment universe and the freedom to adjust these allocations as the outlook changes is a powerful combination.