Four ways to use passive in an active strategy
What is your view on the active versus passive debate?
I think we need to be careful about trying to say it’s me or them, him or us, it’s better or worse. It’s neither; you can have both perform a role in a portfolio.
1) As a buffer for listed debt
A fairly easy example of this is if I hold Australian listed debt, hybrids essentially. They have very particular characteristics; they’re floating rate, and if I choose to say I don’t want to use a manager for my bonds and credit, maybe I’ll just buy the index because it’s very similar to government bonds, I’ll just use the index as a way to buffer that. I can be quite flexible in using that index if I know what I’m doing, I can buy and sell that index at any time as it’s listed on the market, I don’t take any manager risk. I would know the duration of the portfolio; I know how it might react at certain times. That could make sense, but you have to know what you’re doing.
2) As a buffer for a concentrated portfolio
For example, let’s say I hold a global highly concentrated portfolio, and my global portfolio has forty stocks or less in it. It makes sense to hold a simple MSCI World passive index because that manager cannot possibly outperform all the time, you’re hoping it will outperform over a 5 or 7-year cycle. With so few stocks in it, it’s inconceivable that those stocks will always be out-performing. You may not enjoy the volatility of that ride and the possibility that the manager has misread the circumstances. So why not have that buffer?
3) To express a short-term tactical view
If I am trying to express a tactical view that the dollar’s going to move, it can make sense to use a passive index to express that view. Large global investment houses most commonly use indexes to express relatively shorter views.
4) As an alternative to using a manager that you’re not comfortable with
If I’m uncomfortable with the active manager that I’m using at the moment, but I don’t want to be out of markets, I would use passive to remain in the market until I’ve made a decision. That way I don’t hang around with the manager that I don’t like, I just go passive then I go back into the active when I find a manager that suits me.
Cost is low on the list of considerations
There’s a whole host of reasons to use passive management; the worst reason is that they’re low cost. Cost is a benefit for passive, but it shouldn’t be the predominant driver, it might be number 7 or 8 in the pecking order.
Some ‘passive products’ are not as passive as they seem
It’s really important to understand what you’re buying in either circumstance. If you’re buying passive, are you just buying a straight forward, recognized index like the MSCI All Country World Index or well-known bond indices? Or am I buying a fund that says it’s an exchange traded fund, but it’s actually not passive, it’s making active decisions about the weighting of companies? Equal-weighted it is not a passive approach, it is an active approach. It’s saying ‘I’m going to equally weight all companies as though they have the same merits and that the markets valuation of the company is wrong.’ It is an active decision. Once you go down that path, what benchmark are you going to use to say whether the person giving you that ETF is actually doing a good job or not? When you get down to some of the esoteric ones, do you really know and understand whether that has been a good decision? Why is it a good decision? Is the organization providing the ETF doing a good job? There are quite big differences.
One final example, let’s look at emerging markets, which are my favourite kind of market at the moment. You can buy a fund based on the MSCI Emerging Markets Index, or you can buy a fund based on the FTSE Emerging Markets Index. They should give you a completely different experience. One includes Korea, and one doesn’t include Korea. One’s got a lot more stocks. The FTSE Index doesn’t include Korea and it’s got a lot more stocks compared to the MSCI Index. They have had quite different performances over the last few years because Korea’s quite important and the diversity of stocks matters. You really need to understand why you would differentiate between those two and which portfolio it might suit.
Think about what you’re trying to do
It is not as simple as just going passive or going active, give some thoughts to what you’re trying to do, the reasons why, and appreciate what underlying asset are in each of these strategies.