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Beyond active versus passive: how to select your investment style

Glenn Freeman  |  29 May 2019Text size  Decrease  Increase  |  
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The way managed funds are used by investors is constantly changing, and the active-passive debate is largely useless in helping investors identify sources of return.

Because every investment decision is an active one, it's more useful to think about a blend of approaches across the various parts of the total universe of product types, according to the BlackRock Investment Institute.

The use of managed funds by investors has been changing in recent years, say Jean Boivin, BlackRock’s global head of research, Lisa O'Connor, investment head of BlackRock model portfolios, and Simona Paravani-Mellinghoff, global head of investments.

A study of financial planners in February 2019 found a decline in their recommendations of managed funds: 46 per cent of those surveyed recommended new clients use these investment vehicles, down from 54 per cent in 2016, according to Investment Trends.

Breaking this down, the decline is driven almost entirely by actively managed funds.

The rate at which advisers recommend active funds fell to 33 per cent over this period, from 40 per cent in 2016 – while indexed options stayed relatively static at 13 per cent, down from 14 per cent in 2016.

While these numbers are quite clear, BlackRock argues a more detailed assessment is required, and that investors using managed funds within their investment portfolios can benefit by knowing more about where their returns are coming from.

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BlackRock suggests investors are better served by following an approach that uses a variety of methods, including factor investing. Factor investing chooses securities on attributes that are associated with higher returns.

Two main types of factors drive returns of stocks, bonds, and other factors: macroeconomic factors and style factors.

Know your alpha

A few terms need to be explained first:

Alpha refers to investment returns above those received by the broader market. For instance, if the ASX 200 index – a grouping of the largest 200 Australian listed firms – returned 7 per cent over three years, any return above 7 per cent is considered alpha.

Information ratio. Also known as appraisal ratio, this refers to a measure of the risk-adjusted return of an asset, such as an equity. This active return is divided by the amount of risk the manager takes relative to the benchmark, and is often used as a way of measuring a portfolio manager's skill.

Changing the way you think about returns

What are factors?

Factors are persistent drivers of return, which can be used in repeatable methods to capture the higher returns from various types of assets, such as stocks and bonds. The two main types of factors are macroeconomic and style.

"Factors clearly need to be integrated into any investment framework, we believe,” say BlackRock's Boivin, O'Connor and Paravani-Mellinghoff. They several academic studies that have changed the way professional investors think about alpha - including works from Barr Rosenberg in 1985, Eugene Fama and Kenneth French in the mid-1990s, and William Sharpe in the 1990s and 2000s.

Primary drivers of return

In a broader sense, the term is used to explain returns across asset classes. Put another way, BlackRock describes them as primary drivers of returns that have historically rewarded investors for taking on non-diversifiable risks.

  • Economic growth - exposure to the business cycle
  • Credit - the risk of companies defaulting
  • Real rates - Risk of rising interest rates
  • Inflation - risk of changes in cost-of-living
  • Emerging markets - Exposure to political and sovereign risk
  • Liquidity - exposure to illiquid assets.

These focus more specifically on investment returns within asset classes. Historically, these have rewarded investment profiles that either take greater risk, benefit from specific behaviours within the market, or structural change within one or more sectors of an economy or market.

Finding your best style

The term "style" here refers to attributes used by professional investors focusing on either equity or fixed-income funds. The main style factors are:

  • Value - companies priced at a discount
  • Carry - using currency changes to harvest income
  • Size - small versus large companies
  • Momentum - investing based on trends
  • Low-volatility - less variation in patterns of return than the broad market
  • Quality - companies with high-quality balance sheets.

BlackRock's paper refers back to a theory – introduced by Sharpe in 1991 – that active fund managers overall achieve investment returns of little more than zero, and actually turn negative when allowing for costs.

"An investor needs to maintain top-performing managers over time, otherwise alpha will be elusive,” say Boivin, O'Connor and Paravani-Mellinghoff.

"Our work also suggests that individual managers rarely stay in the top quartile."
Their whitepaper finds a collective approach that blends the returns of "alpha-seeking" funds is more appropriate for investors who are prepared to pay for actively managed funds.

BlackRock's taxonomy of returns factors and style investing

 

 

In their analysis, Boivin, O'Connor and Paravani-Mellinghoff used a Morningstar database of the historic investment returns achieved by more than 4,500 fund managers across 21 asset classes in public markets.

They used findings from this Morningstar study to answer two key questions:

  1. How do investors allocate their ‘risk budget’ to chasing alpha?
  2. How do they account for the influence of different factors on asset allocation?

Digging into the concept of alpha more deeply, the report looks at where alpha occurs in different sectors – companies in every type of industry will perform better than average. It also finds this has very little effect on the overall risk in any given investment portfolio.

BlackRock looked at the investment performance of some of the top-performing fund managers over a 20-year period, and found clear differences in the information ratios of higher alpha and active strategies.

Applying BlackRock findings in the real world

Regardless of how investors prefer to construct their own investment portfolio, BlackRock's experts believe an understanding of the above concepts can be helpful.
There are three key ways investors can use this in the way they think about:

  • risk tolerance
  • the investment returns they need
  • the time they have to available to oversee various fund manager

Risk tolerance means considering how much of your overall capital should be devoted to different "alpha sources", or types of fund management strategies such as active, index or multi-asset.

Boivin, O'Connor and Paravani-Mellinghoff believe a holistic approach is more than just deciding how to spread your capital across different fund managers.

Finally, because most investors have limited amounts of both time and money, your own considerations about how much of each resource you want to spend is crucial.

Investors must determine whether they have the research and resources to oversee alpha-seeking managers and consistently achieve alpha.

In many cases, opting to oversee just a few fund managers, or even opt for an entirely index-driven portfolio is preferable, depending on individual circumstances.

is senior editor for Morningstar Australia

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