Blending passive and active funds in a portfolio

Posted by Liz Rees in Latest insights category on 02 Jun 20


Passive funds - do what they say on the tin

Passive funds offer a simple way to get exposure to a market by tracking an index. Although they are unlikely to beat the index, they are also unlikely to underperform it by much either.

Costs can have a big impact on the returns investors get and these are kept low as the investment process is largely automated and there is no need for detailed research.

Some funds may have a higher tracking error than others, depending on how difficult it is to replicate their benchmark. For example, it should be straightforward to buy all the companies in the S&P 500, but not so easy to gain exposure to every constituent of an emerging markets index.   

It’s also worth bearing in mind that some indices, such as the FTSE 100, are more concentrated in a few sectors, so you may have high exposure to areas that are risky or don’t match your personal preferences, such as ethical standards. Likewise you end up owning a mixture of good and bad companies, as well as expensive and cheap companies.

The case for active management

When market conditions are more challenging, the skills of a fund manager with experience of investing through economic cycles, may be valuable. A professional investor, whether running a fund or an investment trust, has the advantage of privileged access to companies.

The key differentiator of a good manager is the ability to add insight from his research and pick the companies best placed to do well, whilst avoiding those with poor prospects. However, there is no guarantee he or she will make the right choices so it is important to investigate their process and track record.    

Fund managers often build their reputation by adopting a defined style, whether growth or value, and sticking to it. At the same time they must demonstrate a talent for stock selection. 

A blend of both?

Investors can opt for a blend of active and passive styles. This may involve a passive core, complemented with some carefully selected active funds to enhance performance.

Passive funds tend to work best in efficient markets such as the US, where there is less scope to exploit mispriced opportunities. In under-researched areas, such as smaller companies and emerging markets, the expertise of an active stock-picker can reap rewards. 

When markets are falling, a passive fund is likely to suffer the same as the market, whilst active managers might be able to avoid the worst of the falls. That said, not all active managers will perform well at the same time. When a portfolio differs significantly from the index, returns can diverge for lengthy periods in either direction.

Even the most skilled managers can suffer when their sector or style is out of favour. Therefore, it is important to do your own research. This will also help ensure you are positioned in the right areas to match your risk profile and your goals. 

The services of a professional come at a cost (and returns are not guaranteed) but what matters most is value for money. Most people don’t mind paying extra for consistently good performance. However, beware of ‘closet trackers’ which have high fees yet simply hug the benchmark.

Fund options

When it comes to choosing from the large funds universe, our research partner Morningstar carries out in-depth research before awarding its analyst ratings.

Funds in our Focus 50 with a prestigious gold-rating include Merian UK Smaller Companies, First State Asia Focus and Fundsmith Equity, whose well-regarded managers have a high conviction style. For a passive approach to the US market L&G US Index Trust has a silver rating.

Getting asset allocation right can be as important as fund selection and if you prefer to delegate this to a professional, a multi-asset solution may worth considering. Willis Owen offers a range of Morningstar-rated ‘Ready-made’ portfolios, using active or passive funds and designed for different risk appetites.