The investment landscape has become increasingly complex in recent years, with an ever-growing range of options for advisers to discuss with clients.
While many clients are happy not to delve too deeply into the nuts and bolts of their portfolios, others will want to know more detail about funds, how much exposure they have to different markets, and how the returns they have made have come about.
And in this increasingly cost-conscious world, clients also want to know what they are paying for their investments and why some funds cost more than others.
There are many ways to approach this conversation with those clients keen for more information, but some key principles apply.
For us, the starting point when discussing active funds is to explain the basics. We tell clients that by investing actively, you are requiring a return that will be different to the stock market.
The underlying promise of active investment is clearly to provide alpha, and making the point that this is not guaranteed is crucial. However, over the long-term, we would expect the funds that we invest in to produce a return that is both different to the market and also in excess of the market.
The other positive to get across is that the funds are in the hands of a professional. Fund managers should be conducting fundamental research on the companies in which they invest; they are not simply buying companies because they make up part of an index, and that expertise brings peace of mind.
Of course, you want to be clear that there are negatives as well as positives. The higher fees need addressing, but telling clients that the fee is accepted for the expectation of higher returns, helps them understand why they are paying them.
On the downside, the performance of active funds can differ greatly from the broader stock market, and they can underperform for significant periods. It is here that an adviser’s knowledge is crucial to reassure clients why the performance is what it is and ultimately help decide to sell a poor fund if it lags for the long-term.
As advisers know, passives provide lower-cost exposure to markets, and here the key is to get the tracking error – the difference between the fund’s return and the index it is tracking – as low as possible to provide as complete a replication of that index as possible.
Clients need to know that this is also a purely binary decision; there is no fundamental research conducted on the stocks that it buys. They need to be clear that it buys stocks without considering the value, the price, the management, or the profitability of the company.
The other main consideration to get across to clients when it comes to passive funds is exactly what their passive is replicating; namely, what are the rules that govern its exposure? Many track mainstream indices like the S&P 500 in the US, for example, but it’s crucial to check this, and how often it rebalances.
The best of both worlds?
Some advisers prefer to have passive funds only for clients’ portfolios because it brings the overall cost of their offering down, whilst others prefer active funds.
Every client’s needs are different, so the ideal portfolio will vary depending on circumstances. Still, there is much evidence to suggest passives perform better in some markets, whilst actives can be used in others (typically less mainstream ones) to help deliver returns.
There are hundreds of studies on the active vs passive debate, but the broad point stands that markets that are covered by thousands of analysts – such as the US – are harder for active managers to outperform, whilst areas where there are fewer analysts – such as emerging markets, or smaller companies, provide more opportunities for active managers.
A blend of both actives and passives can therefore help clients control fees, provide the exposure they want, and the prospect of beating markets over the longer term.
Of course, in this world of complex regulation many advisers now choose to outsource to a DFM. Nevertheless, this still requires a decision as to which product range to use, but any provider with comprehensive fund ranges should allow you to use both investment approaches.