More on Active vs Passive
As shown in the illustration below, active investors are often operating on many different levels and they implement security selection based on strategies ranging from fully active all the way to passive.
When we talk about “active investing” today, we are talking about investors who are moving beyond traditional notions of alpha generation. Rather than allocating solely to individual stocks, these investors are seeking alpha at the asset class, country, sector and industry levels, which may provide more opportunities to exploit mispricing that exist due to macroeconomic factors.
In addition, smart beta strategies offer investors access to a hybrid approach—blending the alpha-generating potential of active management with the low cost and transparency of passive approaches.
In my meetings with clients, I often find investors implementing a passive tool to get active results. Below are the three most common types of situations that I’ve seen for equities (for now, bonds are a story for another day).
When it comes to the truly active, stock-level category, the spectrum is just as diverse. Some managers will seek higher absolute returns, while others will seek to provide high levels of income. In some cases, the active manager is not aiming to outperform a benchmark, but rather may be trying to mitigate risk or provide an uncorrelated return stream—two very important factors in the portfolio construction. The latter point underscores how the active vs. passive discussion largely misses the mark on what clients care about most: how to find growth and income, while managing risk.
Ok, Active is Passive and Passive is Active. So now what?
There is no one right way to invest when it comes to combining active and passive strategies, and several factors may drive the decision to use one strategy over the other. No matter how you ultimately decide to combine the strategies, meeting the three true portfolio goals of income, growth and risk management—is paramount.
1Factset, as of 3/31/2019
2Bloomberg Finance L.P., as of 3/31/2019
Active Management: A portfolio management approach that uses a human hand, such as a single manager, co-managers or a team of managers, to select, adjust and change a fund’s holdings over time.
Active Quantitative Management: A systematic investment process, based on economic fundamentals, that seeks to uncover the market inefficiencies which drive security mispricing.
Alpha: A gauge of risk-adjusted outperformance relative to a benchmark.
Enhanced Indexing: An investment approach that is a hybrid between active and passive management that includes use of index funds and other elements in a way that is meant to outperform specific benchmarks.
Fundamentals: The qualitative and quantitative factors that contribute to the financial condition and valuation of a company, security or currency. Fundamentals include macro variables such as the health of the overall economy as well as micro variables such as a company’s financial balance sheet or management team. Excluded are “technical” factors such as price and trading patterns of securities.
Passive Management: An investment strategy that removes the active human hand from the process and replaces it with systematic, rules-based approaches to securities selection. Passive investing, notably index investing, is relatively cheap because it typically limits portfolio turnover and because the passive investing does not involve relatively costly research.
S&P 500 Index: A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
Smart Beta: Smart beta is a set of rules-based index investment strategies that are alternatives to first-generation market capitalization indices. Smart beta indices isolate particular “factors”—small size, value, high yield, low volatility, quality and momentum—and are designed to outperform cap-weighted indices.
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