When allocating funds in a portfolio, one of the questions investors face is whether to use active or passive funds. Jocelyn Jovene, senior editor Morningstar France, shares his perspective.
Active managers try to beat their benchmark. They will try to pick the best countries, sectors or stocks, and gather them up in a portfolio with the expectation that their return after fees will be above their benchmark index. Active fund management works on the premise that they can interpret information much better than other market participants and generate superior returns. While some deliver impressively, not all do.
The reason for this underperformance is simple, according to the tenants of Efficient Market Hypothesis: investors compete to exploit with a profit any available information about earnings, macro and many other factors that affect the value of public companies. Stock prices adjust so quickly it is almost impossible to find mispriced stocks and exploit them for a profit.
The problem with this theory is that it claims that those few who do indeed beat the market consistently are just riding on luck. If that's the case, does it make sense to pay an active manager and when?
If you're looking for asset managers who can beat their benchmark in a market that is not completely efficient or not efficient all the time, then you can employ the skill of an active manager. Technically this should be the case for any market, including the U.S., despite its reputation of being one of the toughest markets to beat over the long run. Undoubtedly, there are times when being active and daring to act and be contrarian can lead to outperformance.
Pointers to keep in mind when looking for active funds.
- What are the key factors behind the manager's ability to outperform (stock-picking skills)?
- Does the manager have a disciplined and consistent process?
- Are their interests aligned with their investors (i.e. are they rewarded for their lasting impact on performance and not just for taking risk)?
- Are the fund’s fees (expense ratio) commensurate with their ability to deliver value? Morningstar research across the globe has demonstrated that fee level is indicative of future fund performance. Higher fees hinder returns.
- Is the fund's size adequate to deliver reasonable performance (not too big or too small)?
- How liquid are the assets in the fund? In the event of market volatility, investors want to make sure that the fund manager can exit some positions if necessary (although we usually recommend staying calm and not panic in such situation).
- Are risk management processes in place? A poor risk management culture at a firm can harm performance and investor return.
- How often does the fund manager turn over his portfolio? Buy-and-hold is typically a sensible investment strategy, and good fund managers are usually disciplined both in their buying and their selling. They also dare to be different, which means their active share can be significant. But trading too much racks up costs, which eats into your returns so watch out for a manager with very high portfolio turnover.
- What is the culture and resource of the fund firm? As well as doing your homework on the individual manager running a fund, it pays to take a look at the company he works for. The skill, culture and resources available to a manager are important aspects to check. The longitude of the fund manager’s tenure or the investment team also matters.
The best performing investors are usually those who are disciplined in their process, who respect their mandate and keep fees at a reasonable level. A positive is those fund managers who are usually personally invested in their funds.
Most importantly, your own ability to accept market volatility and stick to your guns is also important.
If you are still confused, consider a blended approach.
Having said that, don’t view it as an either-or situation. In ETFs are not only for passive investing, we explore having both in your portfolio. The debate over whether investors should use active or passive strategies in their portfolios has traditionally been viewed through the lens of outperforming a benchmark. In reality, both can co-exist in a portfolio where an investor can follow a blended approach.
In India, the options are still limited. Investment analyst Mohasin Athanikar says that “Currently in India, only domestic equities have index funds or ETFs representing different market segments (large/mid/small caps) as well as the broader market. Passive international equity exposure is offered by a handful of funds, which are entirely U.S. focused. There are a few India domiciled passive funds offering fixed-income exposure in India, such as Liquid ETFs, 10-year gilt ETFs, and the Bharat Bond ETF which invest primarily into AAA-rated PSU entities and G-secs and have a run-down maturity restricting investors from selecting a target duration.”
Mohasin tells you more on that front as he guides an investor on How to opt for a passive portfolio.