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Active/passive framework valuable for SMSFs

A new decision-making framework that uses four variables to assist investors in deciding how to implement index investing, an active strategy or a combination could provide a more deliberate process for SMSF advisers and trustees when determining these allocations within their portfolios.

The framework was outlined in a new white paper, “Making the implicit explicit: A framework for the active-passive decision”, published by Vanguard Australia yesterday.

Developed by Vanguard’s global Investment Strategy Group, the four variables for consideration for a given asset class in a portfolio are gross alpha expectation, cost of active management, active risk and risk tolerance.

The white paper underscored that the portfolio construction process begins with establishing an appropriate strategic asset allocation before the evaluation of active and index products.

“Setting a portfolio’s asset allocation is arguably the most important decision SMSF trustees make, and a critical part of that process is understanding how to implement the portfolio asset allocation, which involves deciding on the mix between indexing and active approaches,” Vanguard Australia head of marketing strategy and communications Robin Bowerman told selfmanagedsuper.

“This framework helps SMSF trustees think more deliberately about their decision-making process, which should consider where they are in their journey pre or post-retirement, and how active strategies might help them achieve their goals.”

Bowerman also added indexing is a valuable starting point for all SMSF trustees.

“It means you take the market return as the default position and then allocate to active strategies where you have confidence that approach can add value or tilt the portfolio to suit your risk profile,” he noted.

“SMSFs typically will have a strong allocation to direct Australian shares, often to large-cap dividend-paying stocks. Where an indexing approach can add real value is for access to global markets – both shares and fixed income – which are typically expensive to access directly for an SMSF.

He said SMSFs should think carefully about how an active strategy might complement their goals, beyond just outperformance.

“The value of taking a core-satellite approach and using indexing and active strategies together is that a portfolio’s concentration risk can be offset by the diversification that comes from investing in broad-based market index products like exchange-traded funds.”

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