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The great investment debate

Spring 2006

In our last issue we put the case for a passive investment approach so, in the interests of balance, the debate now continues with the relative advantages of a more active managed approach in this feature.

We put a few key questions to our Managing Director and Chairman of the bank’s Investment Committee, Greg Horton:

In general, are actively managed portfolios more or less efficient than portfolios that use a passive investment approach?

This is an enormous question to start with. Both approaches have their place in a diversified portfolio, but debating which is more or less efficient is generally reflective of no more than different product providers’ preferences.

Active investment managers are primarily driven by two goals: to use a mixture of research, experience and judgement to beat the market by spotting stocks most likely to outperform and to reduce absolute risk.

In contrast, passive investments such as trackers set out to mirror the trend of the market as closely as possible. They reduce the potential for serious underperformance, but offer no opportunity to benefit from the outperformance that a skilled active manager might achieve. Tracker type products work particularly well in rising bull markets, where the investor will also benefit from their reduced management costs, but in a bear market, the active manager’s ability to hold cash can work to their advantage.

Traditional trackers tend to mimic a specific market index such as the FTSE 100 and this can result in investments concentrated in the larger companies that tend to dominate these types of indices. Active managers can offer a more convincing record in specialist areas, small companies and mid capital companies. Active managers are also more suited to inefficient markets where good research can reap higher rewards.

Are passive investments lower risk than active investments?

Where passive investments do reduce risk is in the relative risk of underperforming the chosen index, which is not the same as reducing the absolute risk to the investor.  The main advantage of passive investments is that they generally produce a more consistent performance and reduce the volatility of returns.

On the downside, since trackers are always fully invested in all market climates, they cannot take defensive positions in a falling market in the same way an active manager can by switching to cash.

Do you favour one approach over the other and, if so, why?

Over the long term, the average tracker should generally outperform the average actively managed portfolio because it is more consistent and has significantly lower charges.

In reality though, both strategies have their place and both can work in harmony, as each has its advantages. The passive tracking element will match market returns and risks, while an active element can be targeted to achieve added value. The precise mix of passive index based and active products will depend on a client’s specific investment objectives and risk profile.

It is because of the advantages that both elements can bring that we designed our own Strategic Asset Allocation Service “SAAS”. SAAS comprises a predominantly passive approach, but because it is a multi asset class service, it incorporates the ability to move into cash when necessary, removing the major disadvantage of a single tracker approach. By the same token, the service also features active managers, particularly in inefficient markets where real value can be added through good research.

Why do you think professionals have historically favoured actively managed portfolios comprised mainly of equities?

Basically, because they had so little choice in the past. The industry continues to evolve and there was nowhere near the level of product sophistication or investment awareness available, even ten or twenty years ago.

Today, there is a wide range of investment styles to choose from, but they can generally be categorised into either absolute return or market driven. Each of these styles can be achieved with either a passive or an active management approach.

At Fairbairn Private Bank, we look to accommodate both investment styles and both management philosophies through a broad range of strategies provided either “in-house” or externally.

In your experience, what would an “ideal portfolio” look like? Would it use equities only or would you generally wish to expose clients to other asset classes?

Here the key is diversification, as this is the most efficient risk diffuser. But there is no such thing as an “ideal portfolio”, as one size definitely does not fit all. For example, a client chasing high-risk investment with a high return would have a very different “ideal” to a low risk investor.

If we generalise, however, the greater the diversification, the lower the risk.  The old advice about not putting all your eggs in one basket is not merely about lowering risk, but also about improving returns, because smoother returns compound at a faster rate. Consequently, if we look at a typical low to medium risk investor who is seeking returns above cash, but without taking material risk on the downside, then our Strategic Asset Allocation Service (SAAS) offers an ideal “core” holding. Diversification is achieved by investing across all the major asset classes (cash, bonds, equities, property and alternative investments) and we aim to achieve an optimal mix between required return and risk tolerance. A client is then free to add any number of individual “satellite” investments, perhaps in more actively managed products, all within our Focus service.

If we turn to the needs of the higher risk investor, then a more bespoke approach would be suitable. This may incorporate specific higher risk satellite investments, or involve the use of an active management approach where we would utilize the services of a third party specialist.

Either way, the key requirement for our private bankers is to match the needs of our clients with the service that best suits their risk profile. This is where we spend most time with our clients before commencing any investment process. It is not about selling a product, it’s about building an understanding and delivering on agreed expectations.