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Best of both worlds: blending active and passive investment strategies

Gemma Dale discusses core and satellite investment strategies and how they help broaden portfolio diversification.

SMSF investors have traditionally preferred direct investments over managed products. According to the Australian Taxation Office, managed funds have long represented less than 5 per cent of the average SMSF, while direct-listed assets have comprised nearly 40 per cent.

Investors in this century are now aware of the benefits of diversification, however, and have more choices than ever in how to achieve it.

A well-diversified portfolio, in principle, delivers lower volatility and reduced risk without sacrificing longer-term returns, and the breadth of assets and asset classes ensures there is always an opportunity within reach.

As SMSF trustees and other investors seek broader diversification, particularly internationally, they are choosing to invest in diversified products such as managed funds, exchange-traded funds (ETFs) and listed investment companies (LICs).

Blending these products with a traditional portfolio of direct securities is one way to achieve broad diversification without sacrificing control.

Diversified products – active versus passive

The range of diversified products is huge and often confusing for investors. At a simplified level, the strategies of these products tend to fall into two distinct categories: inexpensive passive (index) products, such as Exchange Traded Funds, or actively managed products that attempt to outperform their chosen benchmarks.

The rise of passive strategies in the past two decades is well documented and is founded on a few simple (if contestable) principles: buying a passive basket of securities is much cheaper than paying for active management, and active management often delivers below-average performance after fees and transaction costs.

Those who support active management argue that professional fund managers can seek out undervalued assets and deliver superior returns over the long run, exceeding the impact of their fees and other costs such as brokerage on turnover.

While the debate between active and passive rages, investors may wonder which strategy will best serve them into the future.

Even Warren Buffett, the most famous active stockpicker of the last century, argues that while his personal record as a successful investor is no accident, most investors would be better off putting their money in the S&P 500 index rather than choose stocks themselves or employ a professional fund manager.

Part of this argument is based on the principle that while many active managers do outperform over time, many do not, and choosing one that does deliver alpha (a return greater than the market return) is difficult.

SMSF investors appear split in this debate: while managed funds (largely active) comprise 5 per cent of total assets, ETFs (almost exclusively passive) make up about 4 per cent.

For investors seeking diversification, it is probable that both active and passive strategies have merit. Passive investing is a safe way of ensuring you achieve close to the market return, but it does require liquid, well-managed markets where information is quickly priced into stocks to deliver consistently better returns than the average fund manager.

Most of the quality research demonstrating the superiority of index options over the average active manager has been undertaken in well-regulated developed world markets with large numbers of active participants.

Active managers are expected to outperform index funds and ETFs in markets where there is less analyst coverage and prices are slower to respond to new information (that is, markets that are less efficient).

One proponent of this strategy is VanEck, one of the world’s largest ETF providers, which advocates active management for less efficient markets such as those in emerging economies. 

Best of both worlds?

One way to blend active and passive strategies is what is known as a core plus satellite approach. This centres around a core portfolio of trusted investments, with smaller investments in more speculative opportunities. The core is expected to generate consistent returns without undue risk, while the satellites deliver growth but may be more volatile.

The proportion of assets in the core compared with the satellites, and what these are comprised of, will depend on your risk profile and timeframe, but the principle can be applied to considerable effect across different portfolios and life stages.

The first step to creating a core plus satellite portfolio – indeed any portfolio – is to determine your risk profile and timeframe to assist in determining the asset classes in which you are comfortable investing.

A simple example is a pension portfolio. As this is required to pay an income stream (based on a fixed percentage under super legislation), many investors and professionals choose to keep one to three years’ pension payments in cash, reducing the risk of having to draw on capital in a market downturn.

The remainder of the portfolio will be based around a core of blue chip fixed-income and equity investments to generate a strong yield, and satellite investments that will generate the growth to ensure overall capital is not eroded too quickly.

A younger person with a longer timeframe, little need for income and a more aggressive risk profile, may have a core of low-cost domestic and international equity ETFs, with a significant allocation to satellite investments in small-caps, emerging markets, private equity and other investments with high growth potential.

How to implement a core plus satellite strategy

While the principles of a core plus satellite strategy are simple, the execution need not be. Two decades ago, when these portfolios started to become popular, retail investors were generally limited to managed funds for both the active and passive components.

Today it is possible for an investor to implement a fully diversified portfolio via ASX or a direct international market such as the NYSE, via a platform, through direct unlisted products, or any combination. The range of products to meet your needs is almost infinitely broad.

For those with a preference for domestically listed products, ASX offers direct securities, ETFs, listed actively managed funds (ETMFs), Listed Investment Companies and unit trusts via its mFund service.

Each product structure has its advantages and disadvantages, and can provide access to bonds, listed fixed income, international and domestic equities, cash, currency, commodities and more.

One advantage of taking the domestic listed approach is that all your investments are held in one place and you can view them all in real time via your broker platform. Those with a full-service broker or financial planner may be more comfortable with a traditional platform; those with a more global approach may prefer to use both domestic and international markets to access their chosen investments.

Traps for young players

The many benefits of diversification and the many ways in which it can be achieved do not absolve you of your ultimate responsibility to understand the products in which you are investing.

The MSCI World Index, for example, only holds developed market stocks and only recently admitted China A-Sshares to its universe, disappointing many investors who believed they were investing in the “world”.

ETFs and other passive products in new markets and highgrowth sectors such as robotics and biotechnology are often based on newly constructed indices in sectors where there will be many losers as technology advances (think MySpace versus Facebook).

Both active and passive managers are required to disclose their objectives, fees and, for passive, their holdings, which makes research a relatively simple proposition. As always, if you do not understand something, do not invest in it.

The trend is your friend

Interestingly, many nabtrade investors are doing exactly what the textbooks recommend: diversifying their portfolios both domestically and offshore using a combination of direct equities, LICs and ETFs.

After a decade or more of holding portfolios heavily overweight in the top 20 Australian equities, reducing their concentration risk and increasing exposure to international and niche opportunities shows a distinct trend toward a core plus satellite approach. Over the long run, this strategy should pay dividends.

About the Author
Gemma Dale , nabtrade

Gemma Dale is Director of SMSF and Investor Behaviour at nabtrade. She is the host of the Your Wealth podcast, a fortnightly podcast for investors, featuring insights and updates from markets and finance experts across a range of topics. She provides regular market and finance commentary on ausbiz and in other media including AFR, the Australian, ABC and commercial tv and radio. Gemma was previously the Head of SMSF Solutions for nab, and the Head of Technical Services for MLC, where she led a team of specialists providing advice to advisers and their clients on SMSF, super, tax, social security and aged care.