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While tempting to make an ‘all-or-nothing’ active vs passive decision, we believe investors should explore the possibility of combining both approaches, thus allowing their portfolios to benefit from the advantages that each have to offer.

t Invesco, we spend a considerable amount of time thinking about portfolio construction. For some of our multi asset portfolios, this means thinking about active and passive investment styles; an old-age and perhaps controversial debate, as proponents on each side are equally convinced that their approach is superior

They offer an affordable way to access markets. The post-GFC (global financial crisis) period has been highly conducive for passive indices to outperform their active counterparts. The range of available passive instruments has increased considerably (e.g. geography, sector, duration) giving investors a wider investment choice.

Nevertheless, passive management is not a cure-all solution. Investors should take note of some of its limitations, including but not limited to:

Passive and active – the case for both

Because each strategy has its own strengths and drawbacks, we think investors should utilise the best of both worlds by employing a blended approach.

The case for a blended approach

INSIGHT

Passive funds have revolutionalised financial markets and they continue to grow in popularity, yet they are not a cure-all solution. In times of market volatility and when exploring areas that require specialised knowledge, active management has a key role to play in portfolios. Investors should capitalise on what’s best from both worlds, say David Aujla, Multi Asset Fund Manager and Fabio Faltoni, Multi Asset Product Director.

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Passive funds – arguably one of the most revolutionary innovations in investment history - have grown in popularity in recent years.

The view on passive

Their numerous benefits have been widely documented. Amongst other things:

The inability to outperform “the market” in rising and, particularly, in falling markets. In volatile times, the tracking error of passive indices tends to increase, making their performance less predictable. Passive indices are often tainted with construction biases, such as a high concentration risk in a limited number of securities.

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Taking full account of the relative pros and cons, we believe it can be advantageous to invest passively where there is an implementation (easy access to a suitably diverse range of investments) or cost (results similar to active management but with lower fees) advantage and actively in less efficient markets where there tends to be more scope to make a difference in performance.

Crucially, none of this is to suggest there is a definitive balance to be struck between both investment styles. Depending on market conditions and other considerations, any number of blends of the two may prove effective.

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The key point is that the need for creative and flexible portfolio construction and asset management is greater now than it has been for a long time and that what worked well in the past might not work so well now or in the future.

Invesco’s heritage in managing multi asset investments for our UK clients goes back over 25 years. Explore our MPS range and turn our expertise into your edge.

While passive managers seek to own all the securities in a given index, active managers select specific investments based on an assessment of their worth. Therefore, rather than “owning the market”, active management aims to “beat the market.”

The view on active

The principal criticism of active management is well known: it is more expensive than passive investing yet has often delivered less performance. So, when and why is active management likely to realise its full, market-beating potential?

Arguably, this should occur in periods of increased market turbulence when there is more dispersion between stock performance. We saw this happen, for example, in the wake of the dot-com bubble burst and, more recently, at the height of the COVID-19 pandemic and after last year’s market correction.

Relatedly, a further appeal of active management is that, unlike passive investing, it recognises the innate inefficiency and irrationality of markets and their participants. Such insights could be particularly useful when exploring opportunities in more specialised areas such as small and mid-cap equities, emerging markets and corporate bonds.

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Investment risks The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Important information This article is for Professional Clients in the UK and is not for consumer use. All information as at 30 June 2023 and sourced by Invesco,unless otherwise stated.

Views and opinions are based on current market conditions and are subject to change. This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.

“It can be advantageous to invest passively where there is an implementation or cost advantage and actively in less efficient markets where there tends to be more scope to make a difference in performance”

Fabio Faltoni, Multi Asset Product Director

“Because each strategy has its own strengths and drawbacks, we think investors should utilise the best of both worlds by employing a blended approach”

David Aujla, Multi Asset Fund Manager

Ben Gutteridge, Portfolio Manager - Multi-Asset Strategies

The dominant elements of the Invesco Investment Solutions team’s asset allocation approach are strategic in nature, meaning our focus is on building portfolios that, for a given level of risk, offer clients the best possible long-term rewards. At the heart of this process is the research effort, executed in a scientific manner by a deep pool of highly skilled analysts. Their chief ambition is to calculate Invesco’s proprietary Capital Market Assumptions (CMAs), which reveal our long-term return forecasts for the various asset classes (which at times have shown strong correlation with actual market performance, as demonstrated by figure 1), as well as ascribing a level of risk and measure of correlation. It is these CMAs that drive the implementation of asset allocation and allow Invesco to construct portfolios in an optimal fashion.

A long-term view dovetails with an enduring approach to fund selection

Though the forensic approach taken to calculate the CMAs adds a layer of complexity to the process, the framework is remarkably simple. Specifically, the calculations are anchored to long-term data sets, such as 10-year earnings forecasts, or 10-year average volatility measures. Indeed, it is this long-term emphasis that results in short-term market activity, such as near-term earnings disappointments or spikes in volatility, having only a modest impact on the CMAs. Such ‘stability’ in the CMAs, therefore, means asset allocation changes have been relatively minor at each update.

Whilst ‘ever-changing’ market conditions can lure investors into acting, or even ‘wanting to be seen to be acting’, such activity can often be driven by emotion rather than fundamentals. To help moderate this risk, our emphasis on strategic decision making removes much of the noise of day-to-day sensationalism, keeping portfolios more closely aligned to clients’ long-term objectives.

“A ‘value for money’ assessment should sit alongside any nominal fee analysis”

Q&A

with...

Ben Gutteridge

Strategic decision making helps remove much of the noise and day-to-day sensationalism within investment, keeping portfolios more closely aligned to clients’ long-term objectives, says Ben Gutteridge, Portfolio Manager - Multi Asset Strategies, Invesco. He also discusses how this approach complements Invesco's fund selection efforts; and why finding a balance between passive and active is key amid pricing pressures.

What is your approach to asset allocation and how does this evolve in an environment of ever-changing risk?

Invesco’s fund selection approach is a concentrated effort, seeking to find high-conviction ideas across a range of asset classes, geographies and styles. It is our ambition to know a relatively small number of funds extremely well, rather than knowing less about more funds.

Your fund selection process of three distinct steps, what are they and what do they emphasise?

The first stage of the process is universe construction, defining and populating multiple bespoke categories of funds. This administrative procedure lets us conduct the fairest possible analysis between funds, but also more cleanly supports the portfolio construction stage of the process.

The second stage is heavily quantitative, distilling a shortlist of funds from the bespoke categories for further research. The quantitative factors utilised varies with each category, as does their emphasis, but common elements include risk-adjusted returns, manager tenure, fund size and flow, upside and downside capture, active share and style drift.

In the final stage of the process, we seek an audience with the fund management team, hoping to gain a deeper understanding of the philosophy and process. Engaging with fund managers and challenging their investment strategy in different market environments can help build a degree of confidence in how the mandate may navigate similar conditions in the future. Meeting management can also prove helpful in determining how the fund seeks alpha generation, and whether such ambitions chime with past success – offering some insight into whether past achievements might be repeatable.

Should a fund succeed in making it into the Invesco MPS it is subject to a rigorous maintenance and review process, with a particularly keen eye on unexpected and outsized performance, personnel changes, AUM volatility and style drift. We should add, however, such is the level of due diligence undertaken in the selection process, that a relatively high bar is set for changes. This long-term approach to fund selection dovetails neatly with the asset allocation philosophy.

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Price pressure is a factor driving flow and the increased use of passive instruments in MPS, how do you balance allocation to active and passive given this trend?

Within Invesco’s MPS, therefore, the passive allocations are primarily determined by our holistic approach to investment, prioritising ‘client investment experience’ and ‘value for money’ over simply ‘cost’. Despite this layered approach, however, there is consistency in decision making across portfolios, meaning some rules of thumb have merit. Specifically, we would suggest a 20% allocation to passive vehicles is a reasonable proximation, covering all major asset classes beyond less liquid parts of the equity and bond markets.

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Quick facts

Figure 1. The CMA for FTSE 100 has tracked realised forward returns closely

The Invesco MPS portfolio construction process pays very close attention to the overall pricing of its service, knowing that costs are a material hurdle for a client’s investment performance to overcome. On that basis, Invesco find passive vehicles an extremely useful component within our ‘toolkit’; though cost is not the only determinant in allocating to passive investments. Lower conviction in active management from certain areas, such as US equities, can encourage passive adoption, as can the need for more targeted investment exposure. Within the fixed income sphere, for example, it has historically been difficult to find active fund managers who own lots of long-dated bonds or ‘long-duration’ assets. Given this shortfall, investing in a passive fixed income vehicle which structurally secures benchmark levels of duration might be a necessary step for risk management purposes. In practice, therefore, core passive fixed income strategies might better help portfolios hedge against negative growth and deflationary shocks relative to those holding only actively managed bond funds.

It would appear those selecting an MPS partner have a rich array of choice. What is more, the level of competition should yield further gains for clients in years to come, given the pricing and innovation pressures these conditions foster. Such choice, however, can also give rise to indecision, so we would encourage investment decision makers to focus on a handful of key metrics:

What factors should advisers consider when choosing an MPS?

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Ben Gutteridge, Portfolio Manager - Multi-Asset Strategies

“Whilst ‘ever-changing’ market conditions can lure investors into acting, or even ‘wanting to be seen to be acting’, such activity can often be driven by emotion rather than fundamentals”

12.0%

9.0%

6.0%

3.0%

0.0%

-3.0%

4/30/98

4/30/02

4/30/10

4/30/18

4/30/22

4/30/06

4/30/14

Source: Invesco as of 30 June 2023. For illustrative purposes only

CMA 10Y Return

Realised 10Y Forward Return

Availability: The breadth of platform availability should offer some steer on the current and future utility of the MPS service.

Price: A ‘value for money’ assessment should sit alongside any nominal fee analysis. Does the MPS management fee seem fair? Are the costs of the underlying funds reasonable? Does the performance and service inform good ‘value for money’?

Investment excellence: Experience should form the centrepiece of any analysis with potential MPS partners. Does the offering party showcase sufficient breadth and depth in their investment capability and does this resource support decision making that aligns with the philosophy of the MPS?

Returns: Performance analysis should reflect several metrics, including returns achieved relative to any stated benchmark or peers, but also risk metrics and whether any volatility targets have been met. Time horizons selected to conduct such analysis are also crucial in this exercise and should be reflective of the ambitions of the client.

Service: Support analysis may come later in the due diligence process, given the natural inclination to first look at price and performance. Invesco believe service should carry an equal weight in determining any final decision. Performance and process tells only part of the story – absent a coherent articulation of what is going on in portfolios and why, it is very difficult to gain sufficient understanding of portfolios. Without such insights it would be very difficult to host genuinely engaging meetings with clients.

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