The key reasoning behind an adviser’s decision to go one way or another could be based on their own ideology, or purely on cost considerations. Certainly, there are several wider considerations for fund selection based on the differences between the two approaches.
For active strategies, core criteria for successful selection would likely be a track record of consistent alpha; a low correlation to an index; a repeatable demonstration of the investment process; a strong, stable investment team; and robust research capabilities.
For passive strategies, the focus would be potentially less ‘human’ and more around the execution of the strategy. For example, demonstrating a low tracking error to an index, minimising divergence risk, delivering this through a robust systematic process, and economies of scale to enable a low fee.
A new dimension
Given the additional focus on sustainability across society and the spectre of new Sustainable Disclosure Requirements (SDR) being rolled out in the UK, ‘ye olde debate’ now has a new dimension.
SDR adds due diligence criteria for fund selection. These include the level of ‘sustainability’ (choose your measure) compared to other strategies, the sustainability aims of the portfolio, and the criteria used to select the companies.
There are several questions overarching these criteria. What sustainable outcome is the portfolio aiming to achieve? Where along the sustainable spectrum does the portfolio sit? Is the strategy employing an exclusion approach, or an impact approach?
At one end of the spectrum, an exclusion approach involves screening out companies that do not meet certain ESG (environmental, social and governance) criteria. For example, the strategy may exclude companies that have a poor track record on environmental issues or those that violate human rights.
A common exclusion approach in sustainable strategies is to exclude or limit carbon to combat climate change. This approach can play a part in enabling net zero targets. It's also a strategy with which end-consumers are beginning to engage. However, this approach typically limits the capital allocated to the worst carbon-offending companies, some of which may be potential sources of net zero transition technology and climate solutions. This nuance is something that end consumers are unlikely to understand at this point and highlights an area where advisers can add value in educating their clients.
At the other end of the sustainable spectrum, the ‘impact’ approach seeks to invest in companies that are making a positive impact on the environment or society. Portfolios may invest in companies that are developing innovative solutions to environmental challenges like climate change. However, in doing so, these companies may have a higher carbon footprint, which could preclude them from an exclusion strategy.
While both approaches have their merits, they appeal to different types of investors. Some might prefer the exclusion approach as it aligns with their values and allows them to avoid investing in companies that they find objectionable.
Educating clients on the nuances of active versus passive versus sustainable, and qualifying their preferences, should be best practice and ‘business as usual’.
Others may prefer the impact approach as it allows them to support companies that are making a positive impact in the world. Key to the FCA’s sustainable plans for advice processes is a robust qualification and evidencing of a client’s preferences (sustainable or otherwise).
We believe that the existing advice process obligations of KYC, COBS and PROD*, coupled with the ‘consumer understanding’ outcome under the new consumer duty, mean educating clients on the nuances of active versus passive versus sustainable, and qualifying their preferences, should be best practice and business as usual.
Irrespective of your views and your choice of centralised investment proposition, industry-leading multi-asset solutions providers can offer you options across passive, active, and sustainable investing (including both exclusion and impact).
Visit our website to find out more about multi-asset investment solutions designed to meet your clients’ needs and long-term investment goals.
*KYC = Know Your Client, COBS = Conduct of Business Sourcebook, PROD = product intervention and product governance