For decades, investors have spent a great deal of time debating whether active or passive strategies should sit at the heart of a portfolio. In this article, Lisa Wang -Head of EMEA Investment Strategy of Franklin Templeton Investment Solutions, says that while the core of the debate remains important, many are spending time on another consideration – where is active risk being taken, and is it being rewarded?
It is a particularly relevant question today. Equity markets have become increasingly concentrated and while investors may believe they are diversified, many portfolios are exposed to a relatively narrow set of return drivers.
With passive strategies dominating flows, a growing number of portfolios are influenced by the same market signals.
For advisers, the core of a portfolio should provide broad market exposure, diversification, reliability and cost efficiency. It should also be something clients can hold through different market environments without constantly questioning whether it still belongs there. Passive strategies have become popular because they do that job extremely well.
But the conversation is evolving, and many advisers are exploring whether the core of a portfolio can work harder while continuing to fulfil the role it was designed to play.
For many investors, generating higher returns is only part of the equation, and how those returns are achieved matters too.
A portfolio that can deliver steady yet modestly improved outcomes while maintaining a controlled risk profile may be more attractive than one that occasionally delivers spectacular returns but introduces significant peaks and troughs in relative performance.
That is why investors are spending more time thinking about the sources of return within their portfolios and how those sources interact with one another.
With investing, conviction is often associated with concentration, as a larger position is assumed to reflect a stronger view. However, that is not always the case, as position size can be shaped by benchmark constraints, risk controls, liquidity, legacy allocations or portfolio construction rules.
Equally, a portfolio may contain valuable sources of conviction that are not being captured as efficiently as they could be. Systematic signals can identify persistent market behaviours, while fundamental research can uncover company specific opportunities.
Each brings something different to the investment process, which is why many investors are looking at how they can be used together.
This is especially important because no single investment style leads in every market environment. There are periods when value is rewarded, when quality dominates or when momentum drives returns.
Investors do not know in advance which signal will lead next. Relying too heavily on one source of alpha can therefore create its own concentration risk.
From a portfolio construction perspective, there can be real value in combining different sources of alpha rather than relying too heavily on any one of them.
For advisers, this has practical implications as it means looking closely at where active risk sits in a portfolio, whether that risk is diversified and whether it is contributing positively to the overall outcome.
It also means recognising that core equity allocations do not need to be limited to pure passive exposure or high-conviction active funds. There is room for approaches that remain diversified, benchmark-aware and cost-conscious while introducing additional return drivers.
Active management and passive investing each bring distinct strengths to portfolio construction. For many advisers, the focus is increasingly on how different approaches can work together within a portfolio rather than where they sit within a particular category.
Strategies that capture a range of useful signals, manage risk carefully and complement existing allocations can help broaden the sources of return within a portfolio. They can also allow advisers to reserve larger active bets for areas where they have the strongest conviction.
Good portfolio construction has always been about making deliberate choices and understanding the role each allocation plays within a portfolio. But deliberate choices alone are not enough – true portfolio discipline demands that we always know where our risks sit, so that nothing comes as a surprise.
As advisers and paraplanners review how portfolios are positioned for the years ahead, understanding where risk is being taken and what is driving returns is just as important as the choice between active and passive itself.
Equally important is the ability to identify and mitigate unintended risks: the exposures that can accumulate across a portfolio, often as a by-product of decisions made in isolation. By maintaining a continuous view of risk at every level, advisers and paraplanners can ensure that the risks they are carrying are always the ones they meant to take.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The writer’s views are their own and do not constitute financial advice.
This information should not be relied upon by retail clients or investment professionals. Reference to any particular investment does not constitute a recommendation to buy or sell the investment.
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