Vantage Investment Philosophy – Part 1: Blending Active and Passive Index Investing in Equity Portfolios
At Vantage, we approach the debate between passive and active investment strategies with an objective lens. Our portfolio construction philosophy recognises the strengths and weaknesses of both approaches. We advocate for a blend of active management and passive investing to create diversified portfolios that historically perform well throughout the investment cycle. Before delving into our thesis, it’s important to understand the nature of these two investment styles:
Passive Index and Active Investing
Passive Investing
Passive investing refers to a buy-and-hold strategy with minimal adjustments over long periods. Returns are solely a function of changes in the price of the underlying securities, whether up or down. Passive strategies are rules-based and do not involve identifying mispriced individual securities. The most common passive investing frameworks are market-cap weighted strategies designed to replicate the performance of benchmark indexes such as the MSCI All-Country World Index, S&P/ ASX 200 Index, or S&P 500 Index.
This strategy disregards the specific characteristics of the underlying securities, requiring no overlay to assess quality, value, management strength, or ethical considerations. Implementation is typically executed via computer-generated trading. At its core, when the price of a security increases, algorithms generate orders to buy more of that security, and vice versa.
Due to minimal human intervention, the cost of this strategy is low. Investors’ exposure is to the components of the specific index, good, bad or indifferent.
Active Investing
Active investing involves selecting securities based on their assessed value, requiring substantial human intervention and judgment. Active investors typically use screening tools to filter securities based on desired characteristics. Once a shortlist is created, detailed analysis begins, encompassing both quantitative and qualitative aspects, such as meetings with company management, competitor analysis, industry assessment, and future prospects evaluation.
The goal is to determine the long-term value of a security and compare it to its current price. Significant discrepancies suggest whether a security is undervalued (and worth buying) or overvalued (and worth selling or avoiding).
Given the extensive human involvement, the cost of this strategy is higher than passive investing. However, if the right securities are chosen, the returns should surpass those of a comparable index, even after fees.
The Case for Blending Passive and Active Investing
The merits of passive versus active investing have been extensively researched and debated. At Vantage, we believe there are compelling reasons for incorporating both strategies in portfolios:
Diversification
Vantage’s model equity portfolios allocate a portion to passive market indexes to provide diversification at the security and sector levels. This base level of diversification is complemented by active strategies which seek to outperform their given index by holding a concentrated basket of securities. This concentration can vary among active managers, leading to a higher risk of deviation from the index. One way to mitigate this risk is to hold a portion of funds in index portfolios, ensuring broad diversification across all industry sectors.
Risk Management
Index portfolio risks are derived from the weighted average of each security’s risk factors, based primarily on market size. There is no active management overlay. At Vantage, we recognise that index fund allocations come with predefined risks. By understanding these risks, we systematically add other securities to reduce risk and enhance returns.
We blend active management styles that incorporate advanced risk and volatility management strategies, such as drawdown controls and stock and sector limits, which are typically absent in passive strategies. Our proprietary qualitative and quantitative analysis allows us to reduce overall portfolio risk without compromising long-term returns. This is crucial for safeguarding our clients portfolios, where consistency of returns and capital preservation are paramount.
Environmental, Social, and Governance (ESG) Considerations
ESG factors are now essential in portfolio selection. As these factors become more integrated into regulatory frameworks and company reporting, active portfolio management is an important consideration when monitoring corporate behaviour.
Active managers frequently screen for ESG factors, excluding companies that fail to meet specific criteria. This aligns with the values of investors who prioritise responsible corporate behaviour alongside financial returns. At Vantage, we understand our clients’ desire for similar outcomes. Purely index portfolios would result in passive ESG outcomes, which may expose client funds to unacceptable long-term risks.
Cost Benefits
Arguments for passive investing often focus on reducing portfolio management costs, assuming that lower costs lead to better outcomes. However, the least expensive option may not deliver the best outcome over time. At Vantage, we guide our clients through the myriad of options, ensuring thorough analysis is not solely driven by cost.
Conclusion
Indiscriminately allocating client investments across an entire market via a purely passive strategy is not optimal. It neglects essential principles such as sensible diversification, active risk management, and protection against detrimental ESG factors.
Blending passive and active investing allows for the construction of portfolios that endure, rather than merely follow market trends. Our investment strategies aim to manage risks while striving for acceptable long-term returns for our clients.
At Vantage, we recognise that our clients have built their wealth through selective, prudent decisions. We see it as our fiduciary duty to champion intelligent, discerning investment approaches that respect our clients’ wealth accumulation values.
* This article contains purely factual information and/or general advice and does not constitute personal financial product advice. The content of this article does not take into account your personal objectives, financial situation or needs and you must determine whether it is appropriate to your situation. We recommend you obtain financial, legal and taxation advice before making any financial investment decision.
About the Authors:
Ben Devenish – Managing Director – Vantage Wealth Management
Ben, commenced work in the financial services industry in 1993 and has held Executive Director, Private Client Adviser, and Responsible Manager (RM) positions since that time. Key responsibilities as Managing Director at Vantage are to manage operational functions to achieve group strategic objectives, stakeholders are engaged to ensure aligned objectives are achieved, and most critically a team-oriented culture is fostered. Read more about Ben here.
Frank Sciarrone – Executive Chairman & Private Client Adviser – Vantage Wealth Management
Frank is the Executive Chairman of Vantage Wealth Management Pty Ltd and VWM Financial Services Pty Ltd. Frank graduated from Curtin University of Western Australia after completing a Bachelor of Economics and Finance degree. Read more about Frank here.
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