This post is also available in: 
Français
Passive funds generally track an index or a basket of securities, and offer cost and tax benefits.
Active managers try to beat the market indexes. To pursue such returns, investors are willing to
pay higher fees to active managers for their level of expertise and market savvy.
The biggest downside for passive funds is that they don’t even attempt to manage investor risk.
When you “buy the market,” which is what an index does; you are buying its returns – both good
and bad. Although they are more expensive, active funds are dynamic and provide the potential
for benchmark-beating returns. Active management has the potential benefit of being thoughtful
about which security and market risks are warranted and which are not. The index, however,
makes no judgment of good versus bad. A key benefit here is that active funds may reduce the
likelihood of having a portfolio of yesterday’s top performers. Active managers like to “buy low
and sell high.”
When you buy an index, you may be doing the opposite at certain times. Of
course, the biggest downside for active management is that at certain times it is tough to beat
the market.
Because both passive and active strategies have advantages, the key is to achieve the
appropriate balance between the two and create a durable portfolio: a diversified portfolio that is
focused on risk management and that can withstand short-term market fluctuations.
So how should investors approach the issue? By taking into account five key points:
First, remember “alpha richness.” There is only so much excess return potential available to
active managers at any given time. In 2014, for a recent example, active equity managers
largely underperformed the market. Some market environments are more favorable to active; some are more favorable to passive. Also, some asset classes are more/less favorable to
active/passive. That’s why blending both can be effective.
Second, keep in mind volatility and dispersion. Higher volatility is good for active managers relative to passive managers because they have the ability to manage risk. Dispersion within the market is good for active managers too because it increases the opportunity to find alpha between securities.
Third, achieve the right active share. Active share measures the percentage of an equity
portfolio that differs from its benchmark. Active managers can only beat their benchmark and
fees if their positions are sufficiently different from the index – an active share of 60 percent is
adequate, while 80 percent is better and considered high active share. This is what the founders
of the active share metric – Martijn Cremer and Antti Petajisto – set out to prove. They found
that during the period between 1980 and 2003 (which they updated again through 2009), equity
mutual funds with the highest active share outperformed their benchmarks, while those with
lower active shares generally underperformed. High active share is a measurement that can
make sure you don’t pay for active and get passive.
Fourth, think long-term. Active management requires more time and patience, and it’s important
to identify the characteristics that tend to outperform over time. Since actively managed
portfolios will endure periods of underperformance, having patience is key. These fluctuations
are the price an investor pays for the chance at long-term excess returns.
Finally, remember that performance isn’t everything. Investments should not be made in
isolation; what really matters when selecting a strategy is how it will fit into the overall portfolio.
Sometimes a simple index fund is the best option. At other times, an investor may want a
specific style or mandate that can’t be replicated in an index. It may also be the case that the
investor is more comfortable with a specific manager’s approach or method. When building a
durable portfolio, sometimes selecting the “right strategy” is more important than picking the
best-performing strategy.
In a dynamic global economy the risks and opportunities within the markets are constantly
changing. It’s only common sense that “all-or-nothing” solutions (i.e., all active or all passive) will
be sub-optimal. A truly durable portfolio should incorporate the advantages of both active and
passive investments.
Add Comment