An active advantage

Jul 04, 2024

The size and complexity of global equity markets mean that returns can be extracted in a multitude of ways. Jeremy Richardson, Senior Portfolio Manager, looks at the differences between passive and active management, the impact elections can have on equity markets and active engagement.

Global equity markets are complex. Some try and avoid that complexity by owning something of everything – the ‘passive’ approach. Others think that there is an opportunity from being selective…or ‘active’.

Both active and passive investment approaches have their place. The truly passive approach of investing in a market cap weighted portfolio of all eligible stocks should ensure market-like performance before fees, but modest underperformance once fees are deducted. As it includes all eligible stocks, a passive portfolio will always own the stocks that perform the best. However, it will also own the stocks that do the worst, as well as those that are expensive or have questionable business models (if the portfolio is truly passive and without exclusions).

Active investors regard this as an opportunity, considering that tilting capital away from expensive, bad businesses should enable an active approach to do better than the passive alternative over time. This requires research that comes with a cost but also enables the delivery of an extra-financial component of the overall return, in the form of active engagement with individual companies.

Active approaches are also more valuation sensitive than passive ones. The more expensive a share, the higher its share price and the larger the holding within a passive portfolio. Some have argued that this introduces style biases by tilting passive portfolios towards Momentum and away from Value. That may not be an issue in a rising market but could be a disadvantage if markets fall. Active investors can mitigate these weaknesses through portfolio construction, but decisions do not always work out, adding potential volatility to investment returns.

When investing in an active global equity portfolio, there is also the opportunity for discussion on ESG practices. Shareholders have a vote and so have the means and incentive to constructively engage with companies. By promoting principles of responsible business, shareholders have the opportunity to help ensure the long-term success of a company. Indeed, that is in the interests of shareholders; which shareholder would not want to be an owner in a well-managed and successful business? However, as companies employ people who have families and live in communities, this improvement is shared more broadly across stakeholders.

This is something that active strategies are particularly well placed to deliver on. Engagement is not simple and takes resourcing to do well. The low fee business model of the passive approach creates an adverse incentive against engagement, and yet engagement is a useful tool for ESG discussions with management and boards. There are no unowned shares, so approaches that focus on inclusion or exclusion without engagement merely make different financial choices but effect no change in the real world. Only active engagement can deliver that, favouring an active investment approach.

Finally, 2024 is ‘the year of the election’. There is inevitable speculation about outcomes but for investors elections need not be bad news. Incumbents like to go to the polls with a strong domestic economy and low unemployment, whilst challengers seek to win approval with policies that they believe will make a positive difference to voters. What tends to work for voters, such as secure jobs, sound money and financial security, can also be good for companies. Moreover, elections are the culmination of policy discussion and the moment at which policy clarity is greatest, given that there will be several years until the next election.

For investors, the milestones passed on the journey towards financial security tend not to be marked by elections but by other macroeconomic events. The dot-com bubble bursting, the global financial crisis and the pandemic were all moments of uncertainty and financial stress that, at the time, made significant differences to the value of portfolios. In contrast, the normal pattern of regular elections typically fails to deliver the same levels of volatility.

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