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Passive funds with active ingredients

Piera Elisa Grassi  |  19 Mar 2018Text size  Decrease  Increase  |  
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Industry flows confirm that passive investing has become the strategy of choice for many investors, who are happy to duplicate market returns for a relatively small cost of investing.

This seismic shift has seen active managers get more “active” in order to justify their management charges and a surge in the number of passive product offerings. In recent times however, it has also spurred a number of innovative “in-between” solutions, such as research-enhanced index strategies.

Research-enhanced index strategies offer an index-like portfolio with a similar risk profile to the benchmark but with the added information advantage of research-driven stock selection insights. This hybrid approach can help to drive consistent excess returns while keeping portfolio construction and the volatility level in line with the benchmark.

It’s a bit like buying the sports version of your favorite car--on the surface it looks the same, but under the bonnet there’s been some clever engineering designed to extract better performance from the engine.

The same, but different

A research-enhanced index strategy has limited deviation from a market-cap weighted benchmark but applies the resources of fundamental research analysts and sector specialists to apply stock-specific views. Based on these insights, the portfolio takes marginal over- or under-weight positions in stocks relative to the benchmark. For example, more weight in the portfolio can be given to companies with stronger growth and return potential (based on the views of analysts who study companies in-depth and meet management), as well as more attractive valuations, helping to improve risk-adjusted returns.

Research-enhanced strategies don’t aim to do a lot of asset allocation relative to the benchmark, or to take big sector bets. Instead they are focused on driving stock-specific alpha by not owning as much of the expensive stocks and owning incrementally more of the cheap stocks that are poised to grow earnings.

For example, one way that analysts rank companies is by forecasting very long-term future cash flow streams. Owning more companies with the best growth prospects and good valuations, and owning fewer of the laggards, is one way to compound incremental excess returns over time.

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Research-enhanced index strategies are designed to be region, sector and style neutral, but can vary in their individual stock holdings within sectors to exploit active insights. What’s important to understand is that over longer periods of time, even small margins of outperformance over the benchmark can compound returns.

As such, this combination of low cost, low turnover, diversification and enhanced insights is designed to offer investors the best of both passive and active management.

Manager selection is key

Choosing a good research-enhanced index strategy requires careful due diligence, since the manager needs to provide valuable stock insights (identifying growth and value opportunities) in addition to providing an efficient, low-cost index replication investment vehicle.

This tends to favour fund managers with large on-the-ground fundamental research teams with deep sector and country expertise, who are able to cover a global investment universe. These managers can harness the power of their active insights to turbo-charge an index-like portfolio of stocks, aiming to improve risk-adjusted returns substantially over longer periods of time versus a plain vanilla tracker fund.

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Piera Elisa Grassi is JP Morgan's lead Portfolio Manager for global and international research enhanced index strategies. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is JP Morgan's lead portfolio manager for the global and international research enhanced index strategies.

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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