What’s in a name?
Uninvolved, unassertive, docile, static, hands-off.
With synonyms like this, it is no surprise that the term ‘passive’ often has negative connotations with investors. In fact, the IA recently released guidance on terminology, where it suggested that ‘passive’ in the context of investing is not always seen in a positive light.
So what does ‘passive investing’ mean?
In broad terms, it involves buying and holding a diversified portfolio of securities for a long time period, with minimal trading. It is cheaper, less complex, and in recent history outperformed most other investment styles, such as active management, over the medium term.
Although a passive investment style can be implemented in different fashions, the most popular is to buy funds or ETFs that aim to replicate the performance of well-known indices such as the FTSE 100 and S&P 500.
These indices are constructed using a set of rules to ensure that they are spread across a number of securities to minimise losses if any of the companies run into difficulty. This means that as an investor, you are less concerned about the individual performance of a company; instead, the performance of your portfolio is driven by the general performance of the market the index is trying to represent.
The construction of an index can be simplified into three steps:
- Identify the universe of securities that will form the index.
- Weight the securities in the index based on a set of rules.
- Reassess both the universe and the weightings on a periodic basis.
For example, a popular index to track the UK stock market is the FTSE 100. The first step is to identify the 100 companies the index will look to include. In this instance, it is the 100 largest companies on the premium section of the London Stock Exchange (subject to a number of other criteria). The next step is to determine each security’s weight. This is done by looking at the value of its shares that are available to trade openly (known as the free-float). Finally, the index is reviewed on a quarterly basis to check if any of the holdings should be removed (because they have fallen in size) or vice versa. This is subject to a buffer zone, to stop companies regularly entering and exiting indices.
A fund or ETF tracking the FTSE 100 is seen as ‘passive’ as the index rules are (relatively) easy to understand, it has low security turnover (due to the buffer zone) and, perhaps most importantly, the weightings are driven primarily by the share price of a company (the higher the share price, the greater its weight in the index).
On the other hand, a fund is seen as ‘active’ if it is managed in an unconstrained way, not restricted by rules or indices.
However, it is not that black and white.
For example, the S&P 500, another widely followed index, places a further restriction on the companies it includes, where it looks to exclude unprofitable companies. Does this extra complexity mean that following an ETF tracking this index isn’t passive? No; it is widely accepted that this would also constitute a passive investment.
At the other end of the scale, indices exist that are based on a very complex set of rules, for example weighting companies based on fundamental factors, such as the profitability of the company, rather than the share price. When the weighting methodology moves away from one based on the share price to one based on fundamental drivers, it is often considered to no longer be a fully passive approach, and has earned the tag ‘smart beta’.
We therefore do not like the terms active and passive: they describe investment styles at either end of the spectrum, but are bad at classifying styles that track more complicated indices. We prefer to classify investments as either index-based or non-index-based, as a better description of how they meet their objectives.
Active asset allocation
In the AJ Bell Growth Funds, we use index-based investments. This allows us to keep the overall OCF of the funds at 0.35% as these tend to carry lower management fees compared to active funds.
However our holdings in different index-based funds is determined by our long term view of different regions, sectors and asset classes. This drives our asset allocation. This asset allocation will change over time depending on how market valuations change, and how we assess these changes relative to long-term economic drivers of financial markets.
Research shows that over 80% of a portfolio’s return is driven by its asset allocation, with a much smaller part driven by the selection of underlying investments. It is therefore important that the funds are able to react to changing valuations and market shocks. Consequently, the funds have an active approach to asset allocation.
Active fund selection
The number of ETFs tracking the FTSE 100 is in double figures. In addition, ETFs and funds exist that are tracking other indices that represent the UK stock market, such as the MSCI UK equity index or the Morningstar UK equity index. It is our role as fund manager to not only assess which index we feel best represents the UK stock market, but then to choose the fund that tracks the index most effectively, when judged on issues such as costs and performance. In addition, we need to assess the financial strength of the fund manager amongst other factors. Although the dispersion of returns is much smaller than seen amongst active funds, it is still large enough to warrant attention, especially when looking at less liquid asset classes such as high-yield bonds and emerging markets. Furthermore, new index funds are launched regularly, and existing funds often cut their management fees, making them relatively more attractive compared to our current choice. We therefore actively assess our available universe of index-tracking funds to make sure the way we implement our asset allocation view will deliver the returns we expect.
Our growth funds are designed to deliver the highest possible level of return for a given level of risk. For example, our ‘Cautious’ fund is expected to deliver a lower return than our ‘Global Growth’ fund over the longer term, however we would also expect it to perform better in the short term if the markets fall quickly and sharply (although there are situations where this may not be the case).
When we launched the funds, we included ‘passive’ in the name to explain that the underlying funds we use are largely following a passive style. However, over the last few years some of these holdings have evolved to invest in funds tracking slightly more nuanced indices.
When we have explained both the active asset allocation and active selection of underlying index-based funds to both advisers and investors, it has often been a surprise to them given the fund contains ‘passive’ in the name.
Therefore, on 6 January 2020 the AJ Bell Growth Fund range will be renamed, removing ‘passive’ from the official sub-fund names. This will not affect how the funds will be run, with index-based funds continuing to be used to implement our asset allocation view. The 0.35% OCF cap remains in place. We hope this will move the conversation from ‘active’ versus ‘passive’ to focus on ‘high cost’ versus ‘low cost’ funds, pivoting to a consideration of whether the fund you are using offers you good value for money.