There are periods in a market cycle when active solutions outperform passive and periods when passive solutions outperform active so we adjust the active/passive blend in the portfolios to reflect this.
As independent asset allocators we believe in the merits of both passive and active fund management.
We cannot ignore stark evidence that there are both periods of significant under-performance and out-performance by active managers. It is worth noting that despite much press coverage, only a small number of active managers have managed long periods of out-performance and a larger number of managers who have notable periods where they add value.
What we find is that there appear to be times when active managers find benchmarks easier to outperform and times when they find their benchmarks very difficult to outperform. Periods of under performance by active managers often coincide with distorted markets where asset price bubbles have occurred as seen in the late 1990’s, the 2006-07 years and more recently. These periods are often characterised by overpriced assets which appear to become dangerously overpriced for surprisingly long periods of time. Periods of out-performance tend to occur after such price distortions, as bubbles deflate and previously maligned active managers soon become the ‘next best thing’ usually at the end of a bear market and the start of a new market cycle.
At Rivers we don't pretend we have the foresight to predict the exact tipping point or market inflection points, but we do believe that if assets, or markets are expensive we should reduce overall risk. Our statistical research tells us that during those periods of distortion when corrections are delayed and prices continue to get more ‘irrationally’ expensive, passive strategies will likely perform strongly. Risk reduction is, therefore, implemented by reducing the exposure to active strategies. The portfolios will, therefore, likely be underweight risk and overweight passives. Our research demonstrates that with this strategy the portfolio is likely to sustain target returns during periods of ‘irrational exuberance’ despite often being overall under exposed to market risk.
Once these distortions have corrected sufficiently and prices have reverted back to normality or indeed have become compellingly cheap, we believe it is appropriate to add risk to a portfolio. This risk should be added through active managers who throughout falling markets or at the start of a recovery or new bull market cycle tend to do well relative to their passive benchmarks.
In a neutral investment environment where risk is average, we would expect the allocation between active and passive to be 60:40. In periods of low risk the maximum active allocation, within the cost constraints agreed on the portfolio, would be 80%, with 20% in passives. During periods of price distortion we would expect the passive allocation to be as high as 60% with actives as low as 40%.
The current active/passive allocation is articulated in published monthly factsheets and the Rivers Capital Management newsletter ‘Current Focus’.