How to max your active-passive mix while controlling cost

Indeed, the most appropriate active-passive mix will differ from one pension fund to another depending on the specific features of the scheme: governance budget, risk appetite, portfolio diversification and numerous others.

Having said all this, undoubtedly there are some pension funds who advocate active management while others prefer to track an index.

The relative merits of each have been deliberated exhaustively in the long-running active versus passive debate. More recently, though, the ongoing Local Government Pension Scheme consultation has put the issue firmly in the spotlight – specifically the concept of ‘active share’.

This is seen as a way to expose ‘closet indexers’ – the funds that are merely active in name as opposed to those that truly do take significant positions away from their benchmark.

This ensures pension funds get what they are paying for – active fees for genuine active outperformance.

As a measure of how much a portfolio’s stocks differ from those in its benchmark, active share is designed to determine the degree of active management in a portfolio, and so can also be helpful as a manager evaluation tool.

Additionally, it can be used to compare the appropriateness of different benchmarks and to check for consistency in a portfolio’s investment strategy over time.

As a result, interest in this measure has been on the increase, with some earlier studies having found that managers who significantly outperform the benchmark have higher active share.

Of course, active share alone is not a predictor of outperformance; numerous other factors such as investment process and philosophy also need to be taken into consideration.

But while active share does not guarantee that a fund will outpace its benchmark, it is worth noting that it will be difficult for a fund to outpace its benchmark if it does not exhibit markedly different positioning.

Alternatively, advocates of the passive approach will argue it is impossible for active managers to beat broad market returns over long periods.

But some investors believe a skilled manager is more likely to do just that in certain less-efficient market areas — those that don’t trade as actively and are slower to react to new information.

In fact, the way genuinely active strategies are managed bears little relation to the way other so-called active portfolios, or closet indexers, are created.

Building a portfolio where your highest-conviction ideas have the largest portfolio weights is the best way to outperform an index over time.

This approach is in contrast to ‘playing not to lose’, where an equity manager owns a large number of securities across all sectors. Truly active managers will look to focus their positions, maximise their security selection and, essentially, play to win.

With this in mind, a common approach for the modern investor has been to hold some benchmark allocations in a passive way to reduce costs in certain efficient markets in conjunction with an active manager to diversify and add the ‘cream on top’.

This gives your portfolio a beta component through the index and a manager to generate outperformance.

Finding the right balance between a truly active manager and a passive index tracker will be dependent upon the specific needs of your pension fund, long-term goals and risk appetite.

But investors must decide for themselves whether high fees for average performance from closet index trackers are acceptable, with active share being a useful tool in identifying this. 

Euan MacLaren is head of UK and Ireland institutional business at Natixis Global Asset Management