Volatility is a bit like spice, as a little adds much-needed flavour to a meal, but too much can be disastrous.
In a recent market update, Flaherty delved into the ideas behind active and passive management and how volatility could be a positive thing for active investment management.
‘It leads to the dispersion of performance, which creates opportunities for managers to earn differentiated returns.’
‘When dispersion is low, there is little that differentiates top-performing active managers from their mediocre counterparts. The value of active management is often questioned in these environments.’
However, Flaherty said volatility can eat into returns through a 'volatility drain' and he said it is important for portfolio managers to dampen volatility throughout the market cycle.
‘This is where active management becomes very important. An active approach requires that a manager pays close attention to portfolio risk measurement and has appropriate policies and procedures in place.’
‘This along with a risk-aware culture, to actively manage the risk embedded in a portfolio ensures it is aligned with the investment philosophy and skill of the manager.’
Conversely, Flaherty said, passive portfolios mean investors own all segments of the market, including the expensive and low-quality elements.
His comments were echoed by Charlemagne Capital’s Dominic Bokor-Ingram. The frontier markets specialist told Citywire Selector the more passive funds there are on the market, the more mispricing there will be.
‘At the moment passive funds are coming in huge sizes, so the active funds that are left will begin to outperform, because there’s more extreme pricing.’
‘In five years investors will say “oh the active guys performed, active is the way to go.” And then you get this herd mentality back into active investing, then the passive guys will perform.’
Bokor-Ingram said it is therefore probably the right time to buy active as everyone is buying passive, but investors need to be aware of changing sentiment.
Bokor-Ingram, who runs several funds at Charlemagne including the Charlemagne Magna New Frontiers fund, said he can see arguments in the more developed markets for the success of passive funds, as fund managers generally won’t outperform developed markets.
‘The level of information in developed markets is just so high, managers in these markets will usually underperform.’
‘In markets like frontiers, things could go very badly if you hold a passive approach. If you are investing in the US market and you want large capital US exposure, it is very unlikely you will find a fund manager that will consistently outperform.’
However, he added, if investors focus on more specialist asset classes there is a need to be more hands on because things have a high chance of going wrong, which means being active makes more sense.