Active or passive?

Investors have long debated the relative merits of active and passive investment strategies and much has been written on the subject. In a nutshell, active investment involves utilising the knowledge, skill and experience of a fund manager (via a collective investment) with the aim of achieving better returns than a benchmark. Conversely, passive investment generally involves using a tracking strategy to mirror the performance of a particular index.

There are some obvious benefits to each approach. Passive investment strategies can make asset allocation and diversification easier. They generally incur lower charges and expenses than active strategies, and broadly eliminate concerns about human error or underperformance against a benchmark. On the other hand, active strategies hold the prospect of generating above-benchmark returns (which passive strategies tend not to offer). This allows top-rated fund managers who have been able to deliver such outperformance consistently, to charge higher fees for their services.

Smart beta

More recently, the line between active and passive investing has become increasingly blurred due to the proliferation of 'smart beta' products. These products aim to provide enhanced returns at the low cost of passive strategies. Traditional index-tracking products have tended to replicate indices based on market capitalisation, therefore encountering challenges such as overweighting overvalued stocks and underweighting undervalued ones.

To deal with these issues, smart beta products may weight themselves using the fundamentals of their constituents, such as dividends, book value or cash flow, rather than just by market capitalisation. Research has shown that such strategies are likely to be able to generate long-term outperformance.

With such a large range of investment strategies available to investors, the debate as to whether active or passive is more attractive is likely to rumble on ad infinitum. However what is clear is that the majority of active managers have managed to outperform the FTSE 100 index over the past year.

One of the more popular exchange traded funds (ETF) that investors use to gain UK equity exposure, the iShares FTSE 100 ETF, returned -5.30 per cent over the year to 30 September 2015, while the average return of funds in the Investment Association UK All Companies sector (representative of active UK equity managers) was +2.49 per cent (financial express); a difference of 7.79 per cent.

So what has led to the significant outperformance of active managers over the past year?

Cost of energy

Generally speaking, active UK equity managers have managed to avoid the mining sector, which has seen large declines over the past year amid concerns regarding China's economic slowdown. The energy sector has also suffered due to the sharp fall in oil prices. Together these sectors constitute a large part of the FTSE 100 index and their weakness has therefore contributed materially to its poor performance.

Furthermore active managers have focussed their attention across the market capitalisation spectrum, investing the capital withheld from the energy and mining sectors into mid and small-cap UK companies. Such companies tend to be more domestically focused than their larger counterparts and have therefore outperformed as the UK economy has shown improvement.

The question for investors is, how long can domestically-focused stocks continue to outperform while mining and energy stocks underperform, given their ever-diverging valuations?

It is inevitable that both trends will have to end at some point. However as it may be difficult to find an active UK equity manager that is overweight in the energy and mining sectors, investors looking to benefit from such a turnaround may have to buy into cheap passive strategies to gain the necessary exposure.

If a turnaround did occur and active managers had not adjusted their positioning, they would likely underperform the FTSE 100 for a period of time. In either case, investors need to be cognisant of such risks when allocating assets and there are times where both passive and active investment strategies can be of use. 

Claire Bennison is regional director at Brooks Macdonald in Manchester

She writes a regular in-practice article on asset management for Private Client Adviser