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How to choose the right investment portfolio

We look at some of the strategic choices facing investors

The investment world for most people is broken down into passive and active management styles. The question is, which is better? Photograph: iStock

The investment world for most people is broken down into passive and active management styles. The question is, which is better? Photograph: iStock

 

When it comes down to it, the investment world for most people is broken down into passive and active management styles. One sets out to mirror the overall performance of a stock market or other index and the other aims to outperform it. The question is, which is better?

“With passive there is no stock picking or forecasting,” explains Mary Cahill, head of global investment selection with Davy. “It offers low-cost access to a broad spectrum of the market. The manager is not trying to outperform the market. There is a downside. Passive funds fully participate in volatility and investors are not always comfortable with that. A lot of them are weighted by market capitalisation – this is a really important concept. If a share price goes up, the fund buys the stock and it sells if it goes down. That does introduce an element of buying high and selling low. That’s an important concept to address.”

Some refinements have been introduced to overcome this. “There have been recent developments in things like smart beta, which tries to give market exposure but overcome the downside of market capitalisation weighting. It might give equal weighting to stocks in order to give greater exposure to smaller and mid-caps. Other smart beta strategies are more complex.”

With an active strategy, investors place their funds with a manager or team of managers who seek to achieve better returns than the market by using their research and skills. “The aim is to create a portfolio that should outperform over time but this does have higher costs,” says Cahill. “There is a ton of statistics saying they don’t outperform and another ton saying they do. There are also reports claiming that some managers are charging active fees for what are effectively passive strategies. Investors should look at the manager’s track record and their strategy and see if they deviate from it. You want them to be consistent in the strategy and to have robust processes in place.”

Of course, nothing is every quite as simple as choosing one strategy or another. For example, KBC offers a range of funds which aim to outperform widely used benchmarks such as the MSCI World Index. The choice of benchmark depends on the investor and their risk appetite, with the balance of equities and bonds in each fund changing to reflect it.

Market conditions

The balance within each fund can also vary, with certain parameters depending on market conditions. For example, the funds are underweight in bonds and overweight in equities at present.

“Interest rates are incredibly low at the moment so most or all of return will come from equities,” notes Hugh O’Rourke of KBC.

Decisions on which equities and bonds to invest in are made by KBC’s team of experts in Brussels. “They make investment decisions based on where we are in the cycle,” O’Rourke adds.

The bank also offers a flexible portfolio which employs a momentum strategy aimed at taking advantage of the direction of movement in the market. It starts each year equally invested in bonds and equities and by the end of the year is 100 per cent invested in one of them. In a period when equities are performing better than bonds, this should result in maximum exposure to them and so on. At the end of each year, the fund reverts to equal investments in equities and bonds and the process starts all over again.

But which strategy is better in the end? Cahill advises investors to do both if possible. “There will be areas where passive or active are more appropriate,” she says. “Take the US for example. The market there is very sophisticated and efficient and there is a lot of data available on companies. Active managers don’t really have the ability to outperform the market there. Contrast with emerging markets. Active managers can do well there as there is less information readily available to investors.”