Active or Passive - Missing the Point!
Many articles have been written about active versus passive management. Active management aims to outperform a benchmark (such as the FTSE-World Index) by careful sector and stock selection. Passive management simply replicates the index and tracks it up and down. An actively managed investment fund will typically cost c. 0.75% per annum. Passive funds are available for 0.10% per annum or less.
The supporters of active management maintain that the process produces superior returns over time (if you select the right fund managers). Supporters of passive management maintain that most active managers fail to outperform and the costs are not justified.
The fact is that these arguments miss the point. There is a place for both management styles in a diversified portfolio. The most important ingredient is active risk management.
Markets go up and down. For long-term investors, comfortable with market risk, buying exposure to probable long-term stock market returns is the most important issue. Fluctuations in value in the shorter term are irrelevant. For these investors, passive exposure to core markets makes sense with, perhaps, actively managed satellite funds offering exposure to smaller markets or specific themes.
But what about investors with less appetite for risk or with shorter time horizons? Traditional asset allocation models diversify into bonds and property on the basis that these assets are less volatile (lower risk) and do not move in line with the stock market (uncorrelated).
The problem with this approach is that it assumes that the risk of investing in a particular asset, and the risk ratio between different assets, remains constant. This may have been close to the truth in the past but it is certainly not the case anymore. The Global Financial Crisis in 2008 highlighted that all assets do sometimes move in the same direction. In 2016, Bond markets were more volatile than equity markets. No end of investors may have felt very happy with double digit returns from “cautious funds” as bond markets soared. But how would they have felt (or will they feel?) when performance goes the other way?
Active Risk Management is not about guesswork. There is an abundance of data available every second which clearly shows the risk levels in any given market or sector. It is possible, therefore, to manage a portfolio so that it maintains a near constant level of risk. Any given level of risk will, over time, deliver a quantifiable return over and above the risk-free return available in the market (i.e. cash returns).
Active Risk Management is not about matching or beating an index. It is for investors who want to be able to plan with confidence. It is about realistic assumptions that will not be distorted by irrational markets. It is about being able to sleep easy at night in the knowledge that you will never be exposed to more risk than you are prepared to accept.
Who is putting their ARM around your investment or pension portfolio?
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