By Michael Karagianis, Head of Private Investment Consulting
Private Investment Consulting (PIC) specialises in building portfolios for high-net-worth clients. Michael Karagianis shares his views on portfolio construction, the importance of asset allocation and the age-old active vs passive management debate.
The relative merits of passive vs active investing raises its head again. I am acutely mindful of the almost religious fervour with which many hold opposing views on this topic. From a practitioner’s point of view, I believe there are complementary benefits potentially available by combining both passive and active management approaches within a portfolio’s architecture.
At PIC, we seek to purpose-build tailored investment solutions focusing on satisfying individual client objectives. Given that a range of studies have shown that asset allocation can account for 80-90% of a portfolio’s outcome over the long term, we have taken the view that the best way to deliver a client’s investment objectives is by focusing principally on the most optimal asset allocation strategy for a client and managing that asset allocation through time.1 This is philosophically quite different to the approach adopted by many in the industry who believe that the primary value-add lies in active stock selection, particularly within Australian shares, to deliver investment outcomes.
On the face of it, an asset allocation focused approach lends itself nicely to the use of passive indexed strategies to manage the underlying asset classes. It is quite straightforward to gain access to cheap passive strategies for a range of asset classes these days via low-cost building blocks such as passive managed funds and passive exchange traded funds (ETFs). These generally aim to replicate the investments and performance of an underlying asset class index or benchmark as closely as possible. An example would be a low-cost ETF tracking the Australian share index.
The chief attraction of using such passive portfolio building blocks is that you can achieve the portfolio asset allocation strategy in a highly cost-effective manner. There is certainly no shortage these days of passive strategies covering a wide range of traditional asset class indexes. That can make passive strategies an attractive option relative to active managers who will invariably charge a much higher management fee.
However, we have to be very careful about overly simplistic conclusions. Much of the criticism of active strategies relates to benchmark relative approaches with relatively low tracking errors. This is where active managers seek to add a bit of additional return or alpha to an underlying benchmark or index – a large number of Australian shares managers fall into this space. I am less compelled by this benchmark relative approach for many of our PIC strategies. The expected (and actual) additional value generated by this approach often doesn’t justify the additional fees.
For PIC portfolios we are instead constantly looking for high conviction active fund managers across a range of asset classes who are targeting an absolute return objective (for instance above the cash or inflation rate) and who manage their strategy in a benchmark agnostic manner. That can be very interesting and worthwhile in a portfolio notwithstanding the extra fees, provided the manager has a track record in delivering.
We are just starting to see the introduction of smart beta strategies into the market. This is an interesting evolutionary step which potentially blends some of the advantages of both active and passive approaches into a single fund. It is early days at the moment but smart beta potentially offers useful portfolio building blocks for the future.
While passive strategies have distinct cost advantages they can have an unfortunate tendency to reward past performance, at the expense of future performance. For instance, a passive Australian shares strategy tracking the S&P/ASX 200 Index will necessarily overweight companies that have gone up the most in price (and hence have greater representation in the Index).
This was a particular problem at the peak of the mining boom when that sector represented more than 30% of the S&P/ASX 200 Index. Now the Index is closer to 15% meaning that a passive investment would have ridden the mining downturn from peak to trough with painful consequences for total returns.
A further consideration is that restricting portfolio implementation to passive building blocks can limit the ability to build more optimal portfolios to meet client needs, particularly in regards to risk management. In the current environment, where valuations of traditional asset classes are generally not cheap and market uncertainty remains unusually high, restricting a portfolio to those conventional asset classes only accessible by passive strategies would result in a relative underinvestment in more alternative strategies that could be very useful in managing risk in this environment. That underinvestment could condemn a portfolio to relatively poorer risk-adjusted returns.
Passive investing can often work well through the early to middle stages of an investment cycle. At these stages, market returns tend to be higher and more predictable. And the benefits of active management may be more marginal. However, the later stages of investment cycles, when asset class returns tend to decline and uncertainty escalates, can be more challenging for passive strategies.
In response to the investment challenges we currently see, we have increasingly sought to allocate to non-traditional alternative asset classes and to investment managers that offer high conviction absolute return approaches to the management of traditional asset classes. The aim is to improve portfolio diversification, risk management and performance.
Introducing greater exposure to alternative investments such as hedge fund strategies, commodities and private equity, can improve overall portfolio risk characteristics and help deliver a more predictable pattern of returns for a portfolio. That is potentially good news for many clients, particularly those in or nearing retirement and wanting to achieve their lifestyle objectives with minimal uncertainty. But it comes at the cost of generally higher management fees to access the best strategies and the risk that these strategies could underperform traditional asset classes. Beyond alternative investments, we also favour a more dynamic approach to managing portfolios at present. The rationale? In an environment of potentially ‘lower than normal’ investment returns but ‘higher than normal’ uncertainty of those returns, a more dynamic investment approach aims to manage risk more effectively. It can help reduce or avoid allocations to investments that present the poorest risk/return characteristics while actively seeking out superior investment opportunities.
We do see a role for passive indexed strategies in portfolios. They work well for traditional asset classes in certain market environments and can certainly help reduce the overall cost of managing a portfolio for a client.
However, we believe there is a strong argument in the current environment for redirecting the savings that can be extracted from incorporating passive strategies in some parts of a portfolio to help fund increased investment in alternative investments and more dynamic, absolute return strategies in other parts of the portfolio. The overall fee savings may not be as great but we expect that the potential improvement in risk-adjusted returns delivered over time after fees, would make it a worthwhile approach to consider.
1. 'Determinant of portfolio performance - 20 years later', Hood R, Financial Analysts Journal, CFA, 2005 and 'Determinant of portfolio performance' Brinson G, Hood R and Beebower G, Financial Analysts Journal, CFA, July/August 1986.
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