Published: 22 March 2019
With markets around the world feeling choppier in recent times, investors would be forgiven for eyeing the prospect of a downturn.
We know though that trying to predict all the ins and outs of any storm that might be on the horizon is likely a futile exercise. Even investment banks and professionals find it challenging to know what to expect and will have different views about how the world economy could shake out this year.
A more practical and realistic approach might be to make sure your portfolio is well positioned to stay on course whatever the weather brings.
When some assets or markets go up in value, it’s generally the case that others will go down. This is where effective diversification has an important role to play. The idea is to maintain your ability to take advantage of good market performance while naturally limiting any damage from exposure to areas of the market that aren’t doing so well.
At its most simple, this means checking your investments are spread across a range of asset classes, sectors and regions of the world so that the risk of being over-exposed to one market area is reduced. For example you might invest in a combination of shares, bonds, funds, cash, property and perhaps some alternative assets (such as hedge funds and private equity).
In fact, academic research suggests that asset allocation - not market timing or stock picking - is the most important driver of portfolio returns over time1.
There’s another factor to think about that wasn’t a prominent feature the last time investment markets went into a sustained slide. It’s only since the 2008 financial crisis that we have really seen the emergence into the mainstream of passive investments.
There is much debate about whether an active or passive fund management style is best for investors, particularly when markets become turbulent. And each has its merits.
While passive investments (such as trackers and exchange traded funds (ETFs)) seek to follow or replicate a certain index, actively managed funds have the flexibility to make decisions with the aim of outperforming a benchmark index and/or their peers.
On the other hand, passive funds don’t have the flexibility to beat the market and boost returns that way, but they do have lower charges that reduce the size of the bite these might otherwise take out of your long-term returns.
A recent surge in popularity (at a time of much greater awareness of charges and their impact on investment returns) means passive investments now account for some 26% of assets under management in the UK, up from 17% just a decade ago, according to the Investment Association’s 2017/18 Annual Survey2.
Unless you have a strong preference for one style over the other, there’s no reason that active and passive investments can’t both play a key role in portfolios. Indeed, certain differences in the way they are managed and structured can allow them to play complementary roles.
For example, one widely used approach is the core-satellite strategy3. This uses low-cost passive investments at the diversified core of the portfolio, to move in line with indices, and active investments as ‘satellite’ or additional holdings that offer the potential for outperformance.
There are also certain areas of investment markets that are easier and/or cheaper to access with passive investments, such as frontier and emerging markets. If you want some exposure to an unfamiliar but potentially high growth area like, for example, small companies across emerging markets, one way of getting it could be to invest in an ETF that tracks the MSCI Emerging Markets Small Cap index4 .
There are other advantages of using both approaches that might depend on your objectives.
If you take a long-term view of investing and are comfortable with riding out volatility, the impact on passive funds of sharp market falls may not be a concern.
If you have shorter term objectives - such as saving for a particular goal – you might be more comfortable with active investments that give you a chance of mitigating the worst of any falls and take advantage of specific opportunities that appear to represent good value.
Ultimately, diversification is key. And diversifying investment styles is another string to that bow.Both active and passive funds can have a role to play in a portfolio, helping you to ensure you’re as well placed as possible to meet your investment objectives, whatever the weather.
This is provided for general information only and takes no account of personal circumstances. It is not a recommendation to buy or sell. It is provided solely to support you in making your own investment decisions. If you have any doubts as to their suitability you should seek expert advice. Alliance Trust Savings does not give financial or investment advice.
Laws and tax rules may change in the future without notice.
Please be aware that the value of investments can fall as well as rise so you could get back less than you invest.
1 For example, studies by Brinson, Hood and Beebower in 1986; Brinson, Beebower and Singer in 1991; Ibbotson and Kaplan in 1999. As summarised by Larry Elkin in 1999.
2 Investment Association - ASSET MANAGEMENT IN THE UK 2017-2018 The Investment Association Annual Survey - September 2019 (Pg 50)
3 Investopedia - A Guide to Core-Satellite Investing - 4 May 2018
4 MSCI Emerging Markets Small Cap
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