Mark Oliver, head of retail at BlackRock Australia, says that in the ongoing debate about active versus passive funds, investors who continue to think in terms of one or the other may miss out on the benefits of strategies that bring together both approaches.
“As investors and advisers focus on building portfolios that are optimized for risk, return and cost, the strategy is shifting to one that blends both active and index funds, rather than one that focuses exclusively on one investment style,” Mr Oliver says.
“For example, active funds are best considered for asset classes that are difficult to represent with an index, such as some emerging and debt markets. An active management approach has the potential to take advantage of the many illiquid issues that are often part of such asset classes.
“Other asset classes, for example domestic equities, may lend themselves to indexing, as they can be more readily replicated and implemented. Indexing can also be utilised for asset allocation strategies.
“By blending both approaches, investors can harness the advantages of each and create a more flexible and diversified portfolio.”
Mr Oliver said that BlackRock is often asked by investors if there are certain economic or market conditions that favour one style over the other.
“Our research suggests that adopting a long-term, strategic framework governing the blending of active and passive, regardless of the economic cycle, is more productive than trying to flip from style to style,” he says.
“Each investment strategy offers its own advantages, suggesting that the most robust portfolio may result from a combination of both.”
Mr Oliver described this blending as similar to an ‘hourglass’ approach to portfolio construction, with greater use of unconstrained, higher return-seeking funds combined with side low-cost passive exposures.
“Investors increasingly realise that attempting to time markets, and trying to trade in and out of stocks or bonds to minimise losses is difficult. Equally, trying to time an active managers’ performance is also difficult.
“Having identified skilled active fund managers, investors should be prepared to remain invested long enough, at least through one economic cycle, to give the manager enough time to generate the positive returns sought.”
Mr Oliver suggests investors should also look for active funds with broad mandates.
“One of the most useful formulas in finance is The Fundamental Law of Active Management, which basically states that an active manager’s ability to add value is a function of his or her skill and the “breadth” of the mandate.
“What this implies is that multi asset strategies – defined as those with a wide range of securities, countries, sectors or asset classes – provide more fertile ground for active managers.”
He noted that on the other hand, there are good reasons to use index funds at the same time.
“The main reasons to use passive funds are cost, precision and flexibility in implementing tactical exposures,” he says.
“For instance, investors may consider passive funds when they are aiming to achieve precise exposure to certain asset classes in a cost effective and tax efficient manner.
“Some narrow index benchmarks – such as large-cap value stocks or medium-cap growth stocks, as well as many fixed income markets – are generally easy to replicate with a passive fund.
“Additionally, exchange traded funds (ETFs) and other index products typically offer a low cost, transparent and tax efficient mechanism to gain exposure to such core asset classes.
“For investors looking for a tactical approach, such as adjusting their exposures to certain markets and asset classes, ETFs are also an excellent vehicle.
“They are liquid and cost effective, meaning it is easy to adjust portfolio exposures based on short-term market conditions.
“Of course, the right blend of index and active investments for each individual investor will depend on their particular risk tolerance and investing goals, but the criteria outlined here identify a worthwhile starting approach,” Mr Oliver concludes.
