Don’t be shy, ask ii...what ratio of passive vs managed funds should I own?

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Alan Chan asks: I have a portfolio of equities funds. Is there a recommended ratio of index vs managed funds that I should own, and is having more funds better for spreading risk? I currently have 11 funds and about 40% of the capital is index and the rest managed.

Dzmitry Lipski (pictured above), head of funds research, interactive investor, says: There isn’t an actual ratio of index vs managed funds that you should own in your portfolio, but there are some basic concepts that could provide more understanding. With the rise of so-called passive investments such as exchange-traded funds (ETFs), which track a stock-market index or theme, the variety of product offering and competitiveness of management charges has also improved. 

Some investors would prefer to have their core portfolio holdings (usually large-cap vanilla vehicles that are expected to be less volatile) as passives following an established index, for example the MSCI World index. On the other hand, specialist areas of the market, which tend to be less efficient (have information barriers, etc), are the preferred place for active managers. That’s because this is where they can add value, although these funds typically carry higher ongoing fees. That said, active managers could also be a core part of a portfolio, but must exhibit strong performance, risk and cost characteristics to compete with the broader market. 

• Active versus passive funds: a beginner’s guide
• The single most important concept for every investor

Spreading the risk is extremely important, but the number of products you own does not necessarily mean lower risk. In fact, it is the correlation between the funds in an individual’s portfolio (commonality of holdings) that matters – the lower, the better. This would diversify the portfolio and limit specific risks. When building a portfolio of funds, you should check whether their holdings differ – building a portfolio of funds that hold the same or similar stocks in their top 10, for example, would leave you overexposed to one individual stock or theme which increases risk. Therefore, diversification at a sector, style or geography level is key, rather than just having a particular ratio of active vs passive investments.