How to mix active and passive funds in your portfolio

Passive management is where the underlying portfolio manager selects securities so as to mirror as far as possible the performance of a given index. So in the case of the FTSE 100 a passive manager might buy all 100 stocks at their index weight. An active manager would buy fewer stocks and look to trade the stocks in order to outperform the underlying index. Active managers try to spot mispriced securities and market inefficiencies that, by definition, passive managers overlook. The average active fund costs about 1.6 per cent a year, whereas passive funds average 0.5 per cent and can go down to 0.1 per cent, according to online investment platform Rplan.

Numerous studies over the years, many done by passive fund providers have shown that passive funds outperformed active funds in the long run. However, most of this research was carried out on very broad market segments as a whole, or in specific markets such as the US.

Chris Wolfe, chief investment officer for Merrill Lynch Weath Management Private Banking, says: "In emerging markets, index funds might give investors too much exposure to sectors (such as financials and energy) and countries (such as China and South Korea) that active managers can avoid with a more targeted approach."

Also, following an index is often seen as an admission that you can't beat the market.

So should you invest in an active fund (which is managed by human beings, with the aim of beating the market) or in passive funds (which are managed by computers and aim to replicate rather than beat the market)?

Hargreaves Lansdown reports that about one in every nine clients hold a tracker or an exchange-traded fund (ETF) in their portfolio, but it's more than one in every six for 30-year-olds.

Danny Cox, head of financial planning at Hargreaves Lansdown, says: "Tracker funds have been available for over 25 years in the UK and have really grown in popularity recently. We see in all cases that investors are happy to mix passive and active investments in their account. If you have invested in a tracker fund or ETF, you probably hold around 20 per cent passive, 80 per cent active funds and shares."

Gary Dugan, chief investment officer for Asia and the Middle East at Coutts, says: "With increasing focus on the cost of funds (active funds can be significantly more expensive), many analysts have pointed out that passive funds will cause less of a drag on total returns over the long term. But investors should also bear in mind that, while passive funds seek to track benchmark returns before fees, they tend to lag their benchmarks after subtracting fees. Depending on the method used to track an index or asset class, this underperformance could be even greater.

"The large disparity in performance of each asset class, depending on whether an active and passive approach is taken, puts greater pressure on the investor to make the right decision between these two options. Often it is not a question of using one strategy over another, but a case of getting the mix right."

Investors Chronicle reader portfolios often show the passive mixed with active approach. This week's reader portfolio is typical in holding a couple of ETFs alongside actively managed funds and direct stock picks.

However, increasingly Investors Chronicle is seeing investors hold too many stocks in their portfolios. Often the answer to this problem is to split your portfolio into a core and satellite, using a core holding in passive funds to reduce costs, surrounded by satellite holdings of actively managed funds and investment trusts, or direct stock holdings that you feel have superior investment prospects. You can use our Top 100 Funds list as a starting point to identify some ideas for active funds.

There are some interesting ways you can use passives to develop a core 'lazy' portfolio.

You only need a few funds to diversify across the key asset classes. This cuts costs and keeps the portfolio manageable. You then rebalance your funds once or twice a year.

One example of a very simple portfolio would consist of three passive funds or ETFs: a broad based domestic equity fund, a broad based foreign equity fund and a domestic bond fund.

However, if you really want to make your portfolio more efficient by choosing the right sectors or geographies in which to use actives and passives, help is at hand.

Rplan's research has found that the case for index tracker funds is far from an open-and-shut case. It carried out research across several sectors, using performance data from open-ended funds, investment trusts* and ETFs with a five-year record, and found that the extent to which actives outperform or underperform passive funds depends greatly on the sector.

*Investment Trust performance was measured using the NAV of the investment trust, as opposed to the share price.

In some open-ended fund sectors, actives have consistently outperformed index tracking funds - in others index tracking funds offer more consistent return prospects.

Chance of picking an active fund that outperforms the average passive fund over the past five years - by sector

Source: Rplan. Performance analysed over 5 years to 26 September 2013.

Stuart Dyer, rplan Chief Investment Officer, says: "Asking investors to choose between active and passive is a false choice. In reality, the situation is more complex; in some sectors, actives generally offer the better returns, whereas in others passives win out.

"In less developed markets, active managers have a definite advantage. In more developed markets, the picture becomes cloudy - in some market segments such as UK Small Caps, active managers can still win, but in others passives may be the better bet."

Rplan admits the study has limitations, as it focuses on comparing active and passive investments at a high level. Passive funds in a given sector could be following a number of different indices, ie. the FTSE 100, FTSE 250 or the FTSE All Shares. Similarly, active managers may benchmark themselves on a number of indices within a sector.

For investors looking at a greater level of detail, further study would be possible to compare, for example, active funds that benchmark themselves to a particular index with passive funds that track that index.

Even if you have decided to use a passive fund in a certain market, you then face the problem that not all passive investments are created equal. Investors need to look into the tracking difference of a passive fund or ETF to find out how closely the fund tracks its index.

You should identify how the index performance is generated. Many ETFs, for example, have exposure to derivatives and counterparty risk. This is not necessarily something to be avoided but investors need to make sure that they understand how the fund they are purchasing is composed.

It's not an easy process to find good active management either. Plenty of fund managers are benchmark constrained, ie. they hold lots of stock in the same proportion as the index that they use as a benchmark for performance. Research earlier this year from SCM Private found 40 per cent of a typical UK equities fund is simply a 'clone' or 'copy' of the overall UK stock market, with that portion being identical in weightings to the FTSE All-Share Index.

However, rplan again steps in to help investors wanting to access the UK market with a list of the top 10 UK funds outperforming passives year on year. As you can see, most of these are UK smaller companies funds.

Top 10 UK funds outperforming passives year on year

Source: Rplan. Performance over 5 years to 26 September 2013.

Note: This compares the performance of individual active funds with the average performance of passive funds within each sector year on year over the past five years.

Rplan has also identified the top performing passive and active funds across a range of sectors over the past five years. Several of the active funds are IC Top 100 Funds: Unicorn UK Income (ISIN: GB00B9XQFY62), F&C US Smaller Companies Investment Trust (FSC), Baillie Gifford Shin Nippon Investment Trust (BGS), JP Morgan Chinese Investment Trust (JMC), Jupiter European Opportunities Investment Trust (JEO), First State Global Property Securities Fund (ISIN: GB00B1F76L55).

Top performing passive and active funds over five years

Source: Rplan. Performance to 26 September 2013. All calculations were performed on data provided by Morningstar.

Notes: *Just two tracker funds have five-year track records. **The study was carried out on overall European funds, excluding those concentrating on specific countries in the region. ***There is only a single passive fund which has invested in UK Gilts for over five years. ****Passive funds by definition will struggle to invest in property because it is hard to buy physical property without the involvement of a manager. As such, this looks at investing in property securities - the stocks and shares of companies that invest in physical property.

How market conditions can influence choice of active of passive

Gary Dugan, chief investment officer for Asia and the Middle East at Coutts, says: "During certain market conditions, active managers should have the upper hand. Where there are large but consistent differences between the performances of individual securities in a market, active managers have an opportunity to add value. However, managers can struggle to prove their worth when the distribution of security returns is wide but very volatile.

"Actively managed mutual funds struggled to beat their benchmarks in 2012, with the average manager underperforming in all major equity markets apart from Europe. Consequently, passively managed funds or exchange-traded funds (ETFs) have continued to see significant inflows of money from investors, many of whom may have traditionally bought actively managed mutual funds."

Chris Wolfe, chief investment officer for Merrill Lynch Wealth Management Private Banking and Investment Group, adds: "Market conditions favoured passive investment strategies for years, creating doubts about the usefulness of active investing.

"While conditions have been nearly perfect for passive managers, they've hurt the best efforts of active ones. Markets have been volatile, and returns across asset classes have been tightly correlated. Just a few winners have carried many benchmarks. In 2011, about 40 per cent of the gain in the Russell 1000 Growth Index came from one stock - Apple - and, at the start of 2012, only 40 per cent of stocks in the S&P 500 beat the index average, less than the odds of winning a coin flip."