Active, Passive & Alternative: an open architecture fund universe for trustees

Insights

Why most investment managers run their clients’ portfolios in a single house style, and why that is a commercial constraint rather than an investment principle

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The Select Model Select

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Author

Tom Wiseman

CEO

Tom is the Chief Executive Officer of Enhance Group overseeing our multi-jurisdictional Monitor and Select solutions from our Jersey headquarters.

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Most investment managers run their clients’ portfolios in a single house style. Some are unapologetically active. Some are mostly passive. None are properly open architecture across active, passive and alternative, because the manager’s commercial structure depends on selling the style it specialises in. That is a constraint trustees inherit when they appoint an investment manager, not one they should be paying for. This article explains how Select is open architecture by design, and why the trustee gets the right answer for each part of the portfolio.

Why most investment managers can only sell one style

Investment management firms are commercial businesses that organise themselves around the products they sell, the people they hire and the story they tell. A traditional active manager has built its team, research process and brand around active investing; it cannot credibly tell clients that passive would serve them better without undermining the foundation it stands on. The same is true in reverse for passive-house firms, and equally for systematic or thematic specialists. A trustee who appoints a single-style manager is buying not just an investment service. They are also buying a constraint on the styles available to the portfolio, even where the mandate, time horizon or asset class would benefit from a different style entirely. Most trustees never get the chance to consider this: the constraint is inherited at appointment and persists for the life of the relationship.

Active, Passive & Alternative: each has its proper role

Open architecture fund investing is not about preferring active over passive, or alternative over either. It is about applying the right answer to each part of each portfolio. The Select Investment Committee approves funds across all three categories; the Investment Consultant selects from that approved universe to build a portfolio matched to each trustee’s investment policy.

Active management earns its fee when a manager’s skill, process and information advantage produce risk-adjusted returns the trustee could not have obtained from a passive equivalent at lower cost. This is more likely in three situations. In less efficient markets, where pricing inefficiencies are larger and more persistent. In specialist asset classes, where comparable passive vehicles are unavailable. And in risk-managed strategies, where downside protection is part of the value proposition. Active management does not earn its fee when applied indiscriminately. In a liquid, well-researched market with thousands of comparable passive vehicles, the typical active manager finds it structurally hard to outperform a low-cost index fund net of fees over the long run. The 5P process applied to active funds is rigorous because the burden of proof on active managers is high.

Passive vehicles, index funds, exchange-traded funds and similar systematic strategies, win on net-of-fees efficiency in efficient, well-researched markets. Broad-market developed world equities are the most obvious example, where the long-run evidence on net-of-fees active outperformance is challenging and the cost gap between passive and active is large. Passive is not free of judgement, however. Different passive vehicles tracking the same index produce materially different outcomes, because of tracking accuracy, securities-lending policies and total expense ratios. The Process pillar of 5P applied to passive funds is materially different from that applied to active funds, but no less rigorous.

Alternative funds occupy a more bounded but distinctive role, covering fund-based vehicles offering exposure to hedge funds, private equity and similar uncorrelated or specialist exposures. The investment case is diversification benefit, inflation protection or specialist exposure that cannot be efficiently obtained through mainstream equity or fixed-income vehicles. Alternative funds typically command higher fees, lower liquidity and more complex due diligence. The 5P process applied to them is correspondingly more demanding, particularly on the Process and People pillars. The IC-approved alternatives universe is intentionally narrower than the active or passive universes.

How Select builds an open architecture portfolio in practice

Open architecture fund investing is straightforward to articulate and harder to deliver. It depends on three things. A research function rigorous enough to test funds across all three categories with the same discipline. An Investment Committee impartial enough to approve funds on merit rather than house style. And an Investment Consultant skilled enough to combine the three categories proportionately for each trustee’s policy. In practice, the Investment Consultant constructs each portfolio by working through the trustee’s investment policy, then selecting funds from the IC-approved universe. Active funds are used where the policy warrants it, passive funds where passive vehicles are the better answer, and alternative funds where uncorrelated or specialist exposure is appropriate. The resulting portfolio looks different for different trustees; the framework is the same, the answer is bespoke.

What an open architecture fund universe means for trustees

Three practical implications follow for any trustee evaluating their existing arrangement against the Select model. First, ‘is your manager active or passive?’ is the wrong question; the right one is whether the portfolio is constructed from the best available funds for each role, or constrained to one style. Second, the cost comparison between Select and a single-style manager is rarely a straight cost comparison; a like-for-like comparison requires comparing all-in outcomes, not headline fees. Third, open architecture is not maximalism: some Select portfolios are predominantly passive, some predominantly active, and some carry meaningful alternative allocations. The discipline is in the framework, not in forcing diversity for its own sake.

The bottom line

Active, passive and alternative are three categories of fund-based investing, each with a proper role in trustee portfolios; the right balance differs by mandate, asset class, time horizon and beneficiary circumstances. Most investment managers can only operate in one style, because their commercial model depends on it. Select operates in all three because its commercial model is built around regulated investment advice, not around selling a model portfolio, so the resulting portfolio reflects the trustee’s policy rather than the manager’s house style.

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