Best of both worlds
Written by Ijeoma Ndukwe
April 2013
The traditional debate of active versus passive is slowly turning into an active and passive approach. Ijeoma Ndukwe examines how pension funds can combine both strategies and get the best out of two management styles
The active versus passive argument is not dead. However the way in which the two approaches are being used to access the market is evolving according to many pension fund investors. The case for blending strategies is gaining momentum.
BlackRock’s 2012 report Blending Insights looked at 35 businesses with combined assets under management (AuM) of around €2.4 trillion to see the extent they were adopting blending strategies. They predicted that in time blending strategies would become the most sought after. In addition, they noticed that current blending methodologies varied: “For those deciding how and whether to blend, the influences and challenges that teams and businesses need to consider are many. Investment philosophy, conviction and clients play a key role. Our respondents expect more change ahead: fee and margin compression,
the squeezing of the ‘middle ground’ of active management, and the evolution of what indexing means.”
Mercer global CIO mainstream assets Russell Clarke attributes the growing interest in blending strategies to a general trend towards more passive management as active managers struggle to beat the market. Where people might have started off with active management, a move towards passive in some areas has led to the two strategies working “in parallel”.
Clarke says that the actual blend varies according to client circumstance such as the cost or tolerance for underperformance in the short term for example. Despite this, he has seen a greater use of passive as the core of a portfolio, while the active management piece that remains the focus has shifted to use unconstrained or higher return seeking strategies.
P-Solve managing director Paul Kemmer says that on the active side, there has been a growing emphasis on the selection of specialists with clients seeking the best manager for each asset class. Furthermore, Kemmer has seen a development in diversified growth funds and dynamic asset allocation over the past few years. He says clients have gone for a rotational type mandate favouring a multi-active approach with managers moving across asset classes and sub asset classes. He says part of this has been driven by a desire for a cash plus portfolio where people are trying to outperform their liabilities.
Kemmer explains: “It wouldn’t be unusual for people to have passive mandates for equities. Bonds would be actively managed and then maybe you might see a manager that moves actively across asset classes, from equities to bonds to commodities to hedge funds. Where asset classes appear over valued you might need a manager to avoid that.”
Clarke and Kemmer both say that blending indexing with active management strategies is allowing clients to get good value in some markets where it makes sense to go passive; at the same time, active management allows them to target what they really need.
Parametric managing director of research Paul Bouchey has noted that over the past four years there has been growing interest in blended strategies and customised versions of the index compared to prior years when most of their investors were solely interested in allocating to the regular capitalisation weighted index.
Vanguard Asset Management presents the case for indexing in two 2012 reports, The case for indexing: European – and offshore – domiciled funds and The case for index fund investing for UK investors, which shows how low-cost index funds “result in a greater probability of outperforming higher-cost actively managed funds”.
Despite the fact that passive investment is commonly cited as providing a lower cost and more secure strategy, many investors warn that passive strategies are not necessarily lower risk. This has resulted in a move towards ‘smart beta’ strategies according to Natixis Global Asset Management head of UK/Ireland business Terry Mellish.
He explains: “The construction of indices can lead to large unintended positions in individual stocks, which has also led to a move to ‘smart beta’ strategies which look to track characteristics of indices rather than a full index due to their sub-optimal structure.”
Affiliated Managers Group (AMG) global head of distribution Andrew Dyson has also seen renewed appetite for ‘smart beta’, which he says is generating interest throughout Europe.
The 2008 financial crisis is not the only event which shaped the evolution of blending strategies over the years. Bouchey says that many of these strategies emerged in the wake of the 2000-2001 technology bust.
“Many institutions and private investors who had embraced passive investing realised that their portfolios were not really being risk managed. They were accepting the market consensus completely and sometimes the market consensus is irrational. I think a lot of the origins of these strategies came out of the tech crash and are also responses to the question ‘can I do better than just drifting with market sentiment in my core equity allocation?’” he explains.
iShares UK head Mark Johnson says: “There are different ways to exploit exposure to a benchmark.” He has seen European countries follow the US approach to index exposure, which involves the blending of passive strategies and not just the blending of active and passive.
Furthermore, FTSE managing director Carl Beckley says the alternatively weighted indices, although passive, are providing alternatives for investors who are trying to avoid the overvalued stocks and sectors that the market cap indices are reflecting. As well as seeing more awareness amongst pension funds, he has noted that over the past 18 months to two years “we have major consultants who are promoting non market cap indices. Two years ago there were virtually none”.
Despite this, J.P. Morgan Asset Management managing director Paul Sweeting argues: “There are some asset classes, such as real estate, where active management is the only approach. In fixed income, too, the advantages of more bespoke strategies are becoming increasingly appreciated. This is particularly true in relation to corporate bonds. It is also worth noting that active management is more effective when the correlation between companies is low, as is the case at present.”
The general consensus is that it’s important to get the mix right which is where the challenge lies. Barbelling strategies are singled out as a significant trend in the UK according to Dyson and other fund managers. Dyson cites barbelling as a good model, which is gaining traction because people have realised that being in the middle in a semi active space is “a losing game”.
He explains: “If you want active, go out and get active managers who’ve got conviction and hopefully who’ve got skill in the game themselves. Likewise, if you want to control use, the passive end of the barbell can do that.”
Although there are swings in popularity between the two management styles, Kemmer believes that both are necessary for pension funds; they need to spend the money where they’re going to get the return either in terms of the market or alpha, but at the same time are much more cost conscious than they were many years ago.
Despite this many investors are unsure if blending strategies are simply a current trend or signal a more permanent end to the rivalry between active and passive.
Ijeoma Ndukwe is a freelance journalist
