Medium and higher-risk portfolios combining active and passive strategies

The debate about the relative merits of passive and actively managed investment funds continues to rage.

Passive investment vehicles aim to replicate the movement of a specific stock market index, such as the FTSE All-Share index, by investing in all or most of the shares that make up the chosen index, regardless of the underlying companies' prospects.

Active funds, on the other hand, usually aim to outperform an index by picking the strongest or the most underpriced companies in it. However, the performance figures show that active managers rarely manage to consistently outperform major stock market indices.

Passive funds were first launched 40 years ago to provide low-cost exposure to stock markets while eliminating the risk of choosing an underperforming investment manager.


A growing focus on fund charges is now prodding increasing numbers of investors towards passive investments, either exchange traded funds (ETFs) or open-ended investment funds.

A beginner's guide to exchange traded funds

Will this lead to investors abandoning investment trusts - which are almost exclusively actively managed? Not if they do their homework.

medium-and-higher-risk-global-growth-active-and-passive-portfoliosMost of the comparisons that have been made have compared index performance with that of actively managed open-ended investment funds, rather than closed-ended funds.

Actively managed funds suffer in such comparisons because open-ended vehicles usually retain a cash buffer to provide payouts to investors who want to leave the fund.

Not being 100 per cent invested can hold open-ended funds back. Investment trusts have an advantage here.

Simon Elliott, head of investment trust research at Winterflood Securities, says: 'The fact that investment trusts don't have to manage their liquidity, as open-ended funds do, enables investment trust managers to make better longer-term investment decisions and outperform open-ended funds.'

However, another aspect of investment trusts can work against them in the short term. Elliott says: 'The structure of investment trusts means their short-term performance can be pushed around by discount volatility [fluctuations in their share price versus net asset value].'

This is one reason why trust experts argue that the performance of actively managed investment trusts versus the indices can only be judged over longer periods.


In making comparisons, it is important to compare like with like. Open-ended funds investing in the UK and US stock markets often aim to cover the whole market.

However, as Charles Cade, head of investment company research at Numis Securities, points out, investment trusts often attempt something different.

Cade says: 'Plenty of trusts have outperformed the markets over the long term, but when making comparisons, you really have to delve into individual trusts and allow for how much risk managers are taking and whether they are investing for, say, yield.

'You also have to look at whether a manager has a particular style bias. The past few years have been particularly hard for value-oriented managers, for example.'

Passive funds are useful for investors looking for broad exposure to certain stock markets. Investment trusts are often more specialised.

In the Association of Investment Companies' (AIC's) UK all companies sector, figures to 1 September show that 10 of the 13 trusts available five years ago outperformed the FTSE All-Share index over the period.

Over 10 years, eight out of the 10 funds available beat the index. Several trusts have a bias towards medium and smaller companies: Artemis Alpha, Mercantile and, of course, JPMorgan Mid Cap and Schroder UK Mid Cap, for example.

In the AIC's UK smaller companies sector, where trusts focus on investing exclusively in this part of the stock market, eight of the 13 trusts listed have five-year records ahead of the common benchmark, the Numis Smaller Companies (ex Investment Trusts) index.

Investment trust boards set their objectives and often their own benchmarks, mainly to give investors a yardstick against which to measure a trust's performance.

Are investment trust boards doing enough to earn their keep?


However, two of the latest trusts to join the UK all companies sector have chosen other goals. Sanditon Investment Trust, for example, is not trying to emulate market performance.

On the contrary, its goal is 'to provide an absolute return in excess of 2 per cent over the rate of inflation (measured by the Retail Prices Index) and to provide low correlation with leading UK and European equity indices'.

The most recent newcomer, Woodford Patient Capital, which mainly invests in UK companies, both quoted and unquoted, says it 'will aim to deliver a return in excess of 10 per cent a year over the longer term'.

One UK-invested investment trust adopts a passive investment policy. Aberdeen UK Tracker, the last of a handful of investment trust trackers, aims to replicate the FTSE All-Share index.

It is hampered by the fact that, however closely the movement of its net asset value may reflect that of the index, the presence of a share price discount (or premium) will skew its actual performance.

The largest investment trust sector is the global sector. The performance of global trusts is often compared with the FTSE World or MSCI World indices.

These indices have proved harder for trusts to beat than the FTSE All-Share index. Recent performance figures show that just eight out of 25 global growth trusts have outperformed the FTSE World index over five years.

Variations in performance have much to do with differences in geographical exposure. In the FTSE World index, for example, the US stock market accounts for 55 per cent of its constituents and the UK just under 7 per cent.


The average global growth trust, by contrast, has just 36 per cent invested in North America and 24 per cent in the UK.

Two of the most successful 'global growth' trusts in recent years have been Lindsell Train and Scottish Mortgage. Both have outperformed the FTSE World index over three, five and 10 years.

They invest very differently, though: Lindsell Train has a 70 per cent exposure to the UK market, while Scottish Mortgage's exposure is less than 10 per cent.

Lindsell Train's stated objective is to achieve positive returns and at least maintain the real purchasing power of investors' capital 'as measured by the annual average running yield on the longest-dated UK government fixed-rate bond'.

Unfortunately, the trust's very high share price premium to net asset value (it ranged between 20 and 53 per cent over the past year) has made it less attractive to potential investors.

Scottish Mortgage aims to outperform its benchmark, the FTSE All-World index, over five-year rolling periods. However, its high-conviction approach can lead to volatile performance.


Passive fund and ETF numbers have grown rapidly in recent years. These offer investors exposure to more stock markets and to specific individual sectors.

However, specialist investment trusts have strong long-term records of outperformance, although it is often even more difficult to make direct comparisons between these and indices. Specialist investment managers tend to find more opportunities to exploit market anomalies.

In the Asia Pacific sector, 11 out of the 15 trusts have beaten the FTSE All World Asia Pacific ex Japan index over the past 10 years.

Over the past five years, all eight of the trusts in the Europe sector are ahead of the FTSE All World Europe index. All five of the trusts in the global emerging markets sector are ahead of the MSCI Emerging Markets index over 10 years.

Some investors are starting to take an all-passive approach. Often they are attracted by low annual management charges, rather than the result of a thorough analysis of performance statistics.

However, many investment experts argue that it can make sense to have both passive and actively managed funds in your portfolio.

With this in mind, in the table above (click to enlarge) we have suggested how medium- and higher-risk growth-oriented investors might construct their portfolios using passive funds to capture UK, US and international equity markets, and a spread of actively managed investment trusts to achieve long-term outperformance in other areas.

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