Building portfolios: The active/passive continuum

When allocating to fixed income, Craig Lazzara, CFA — a Managing Director and Emeritus Global Head of the Index Investment Strategy Group at S&P Dow Jones Index — believes the most important consideration for managers to think about with fixed income is whether interest rates go up or down.

“If you’re in an environment where interest rates went up, then if you’re short duration, you’re going to look good. However, if rates headed down, you’re going to look bad, and there’s not much you can do about that,” he says. “So, with fixed income, there are many managers (80-90 per cent) that either outperform or underperform.”

Nathan adds that the last few years have been particularly interesting for fixed income managers.

“We’re approaching the third year of an unprecedented ‘three-peat’, where the global aggregate has actually returned negative returns for three consecutive years, meaning to buy and hold passive in fixed income has been an unmitigated disaster,” says Nathan.

“For the last 30 years, fixed income managers enjoyed a tailwind, with interest rates going one way — down. Over that time, we had equity like returns in fixed income, but that’s all changed now. What that means is fixed income is probably the one asset class where you can see value-add managers.”

In relation to fixed income, SSgA’s recommends investors split their allocation to bonds and fixed income into different buckets. “You’re better doing that than allocating to the global aggregate,” says Clive. “That’s because there are opportunities for active managers to outperform in different pockets of the market, which means you can get good results by blending passive and active management when building portfolios.”

Vanguard is a signifiant player in the ETF space, with about one-third of its $12 trillion in AUM in ETFs/ETPs. When constructing portfolios, Duncan acknowledges that the proliferation of ETFs in the market is providing managers with greater access to specific exposures.

“Ten years ago, we had about 50 ETFs in the market. Back then, they were broadly diversified index ETFs — your basic ‘meat and potatoes’ type ETFs. Today, Vanguard has approximately 300 ETFs. We’re now seeing a lot more concentrated and niche value-added ETFs coming to market, which can be costly.”

In terms of portfolio construction, Duncan adds: “When using ETFs remember that if you’re concentrating your portfolio, you’re effectively concentrating your bets, and are stacking the odds against you. So, if you’re thinking about building your core with ETFs, go with the broadest and most diversified ETFs at the lowest cost you can access.”

With the proliferation of ETFs in the market, Duncan also cautions portfolio managers to check “under the hood” of these ETFs, which includes looking at the ETF’s benchmark and its costs. “That’s because as these newer ETFs come to market, we’re seeing many of them with higher costs attached to them. So, when selecting ETFs, avoid the higher costs and avoid concentration.”

According to Nathan, Lonsec likes to use ETFs for its core allocations. Nathan adds that he also likes factor ETFs. “Factors are a very efficient way to get tilts into your portfolios. However, factors are not persistent, so you can’t hold a factor for 10 years — there are times to buy and times to sell. Nonetheless, using factors as a trading instrument can be a very efficient way to build portfolios.”

However, while Nathan continues to like basic type ETFs — like broadly diversified index ETFs — he acknowledges there are definitely some interesting factor ETFs available in the market. He adds that whether these factor ETFs are leveraged or speculative — like cryptocurrency ETFs — ultimately, investors need to decide how far they want to dial-up the risk in their portfolio by using these types of ETFs.

“I consider cryptocurrency, like I do with artificial intelligence and autonomous driving, as all being very nascent technologies,” says Nathan. “Watching the evolution of technology is amazing, but with nascent technologies, there’s going to be many losers. Whether cryptocurrency becomes a ‘game-changer’, I’m not sure. I’ll just have to sit back and watch.”  

When it comes to active strategies, how should managers approach illiquid investments — like private markets, infrastructure, and real property?

“It’s a good question,” says Nathan. “Lonsec certainly embraces the idea of having alternatives in its portfolios. However, you only have to go back a few years and the type of alternatives you could access were fairly limited, like commodities and gold. From a multi-asset diversification perspective, this made it very difficult to get a robustly constructed alts portfolio.

“However, what we have seen over the last couple of years is a proliferation of liquid alternatives, but some of these funds have big lock-ups. We’ve seen some unlisted property funds with lock-ups of one year. So, if you do need access to your money, you don’t reach to your alts bucket first — you go to the likes of bonds and equities.”

That said, Nathan believes retail investors should consider an allocation to alternatives, as long as they’re aware their capital may be locked up for a period of time.

“There are more alts coming to market, which retail investors will be able to access, and I believe active management is the way to manage them,” he says.