Building portfolios: The active/passive continuum

By Jayson Forrest

Blending active and passive strategies as part of the overall portfolio construction process does provide opportunities for portfolio managers.

Craig Lazzara (S&P DJI), Nathan Lim (Lonsec), Duncan Burns (Vanguard), and Clive Maguchu (State Street Global Advisors) discuss how these strategies can be combined in portfolios

Passive & active investment management  Craig Lazzara S&P DJI and panel discussion
Passive insights for active management  Craig Lazzara S&P DJI
Craig Lazzara, CFA is a Managing Director and Emeritus Global Head of the Index Investment Strategy Group at S&P Dow Jones S&P Dow Jones Indices
Craig Lazzara, CFA - S&P Dow Jones Indices
Clive Maguchu, CFA is Senior Strategist at State Street Global Advisors
Clive Maguchu, CFA - State Street Global Advisors
Duncan Burns, CFA is Head of Investments for Asia-Pacific at Vanguard Australia;
Duncan Burns, CFA Vanguard Australia;
Nathan Lim is Chief Investment Officer at Lonsec
Nathan Lim - Lonsec

Increasingly, the contrasting styles of active and passive management are being blended by managers when building portfolios, says Duncan Burns, CFA — Head of Investments for Asia-Pacific at Vanguard Australia — who believes passive strategies should be an important part of portfolios.

Speaking at an IMAP Independent Thought Roundtable (in association with S&P DJI) on active and passive management in portfolio construction, Duncan says when constructing portfolios with passive strategies, managers should take a core satellite approach to investing.

“Market data shows that instead of core portfolios being active, there’s been a push to a passive core with active satellites around it,” says Duncan. “When you think about the core, it needs to be broad and diversified.” 

It’s a view shared by Clive Maguchu, CFA — Senior Strategist at State Street Global Advisors (SSgA) — who says he is also seeing more allocation to a passive core in portfolios. He adds there are a number of factors driving that allocation, such as the lower cost of passive management compared to active management. However, Clive concedes there are pockets of asset classes where active management still does make sense for portfolio managers and investors.

According to Nathan Lim — Chief Investment Officer at Lonsec — it’s understandable for managers wanting to blend active and passive strategies in their portfolios.

“A core satellite approach makes a lot of sense,” says Nathan. “When you’ve got a beta driven market, why pay for active management? But there are managers that do add alpha persistently over time.

“When you look at Lonsec’s last 10 years of Highly Recommended funds — whether on a mean or median basis — those funds offer an Australian equity sleeve, international sleeve, and even an Australian fixed income sleeve. They not only meet their respective asset class benchmark, they also meet their peer group. So, there is a huge reward in identifying good managers, which isn’t easy.”

Nathan says over this period, the average manager in the Australian sleeve beat the benchmark by 900 points. “So, finding winners matters, which means if you spend time identifying the managers you want to tack onto your core, there is some real value to be delivered.”

SSgA uses a range of factors to form a framework for deciding whether to go active or passive in certain sectors and asset classes. These factors include:

1. The tracking error;

2. The investible universe in an asset class; and

3. The performance of an active manager in an asset class.

“When you look at an investor’s portfolio, you really want to ensure these factors line up, in order to determine whether you use active or passive management to reach the client’s objectives,” says Clive.

Allocating to fixed income

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.”

Proliferation of ETFs

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.”  

Illiquid investments

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.        

About

Craig Lazzara, CFA is a Managing Director and Emeritus Global Head of the Index Investment Strategy group at S&P Dow Jones Index;

Nathan Lim is Chief Investment Officer at Lonsec;

Duncan Burns, CFA is Head of Investments for Asia-Pacific at Vanguard Australia; and

Clive Maguchu, CFA is Senior Strategist at State Street Global Advisors.

They were part of a panel discussion about ‘Building portfolios: The active/passive continuum’ at an IMAP Independent Thought Roundtable (in association with S&P DJI).

The panel was moderated by Toby Potter — IMAP Chair.

 

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