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Unlocking the mysteries of active and passive investing

by | Jun 17, 2015 | SELF-PUBLISHED

Knowing which is which could affect your bottom line

“Active” and “passive” portfolio management used to be fairly straightforward. Active managers traded frequently in an effort to beat the market, while passive managers relied on index-following strategies. But with the increasing popularity of exchange-traded funds, many of which have an active component, the line between active and passive is becoming increasingly blurred. Here’s a look at what it all means.

The “passive” approach to investing is predicated on the theory that markets are efficient, or smarter, than any single person. Studies have shown that the passive strategy on average beats about 80% of professional “active” money managers over time.

When it comes to investment strategy, investment managers generally fall into one of two camps, active or passive. Active managers try to beat the market by buying and selling individual securities in hopes of making enough profit in the overall portfolio that it will beat its benchmark, for example, the S&P/TSX Composite Index or the S&P 500 Composite Index.

Active from the bottom-up or top down

Active money managers often fall into two broad categories: Those who select individual assets using a “bottom-up” methodology, and those who use a “top-down” methodology.

The bottom-up method is most commonly favored by true active managers. This involves intensive research and screening for securities – usually stocks – using traditional fundamental and technical research and analytic tools. And yes, active managers do in fact pore over annual and quarterly financial statements, visit companies and interview management to see what they actually do and how, and conduct intensive number-crunching to determine whether the company is worth buying for their portfolios. “Value” managers – those who focus on finding stocks they believe are trading for less than their true market value – take the “active” portfolio management approach.

Top-down managers come at things from another direction. They look first and foremost at the broader economic and political environment to determine in what sectors, regions, and industries the highest risks and the best opportunities might lie. They then begin researching companies based on sector choices driven by their macroeconomic outlook.

Many mutual funds – both equity and fixed income – take an “active” portfolio management approach. Some say they do, but are in fact “closet indexers,” that is, funds whose performance closely tracks their benchmark. To uncover closet indexers, check a fund tracking service like FundLibrary.com to see how closely a fund matches its benchmark’s performance over the long term, or by how much it outperforms its benchmark.

Passively following the market

The passive approach to investment management hinges on the belief that the market is generally efficiently priced, and as such, it makes no sense to attempt to “beat” the market, because over the long term, portfolio returns “revert to the mean” – they’ll end up pretty much reflecting broad market returns anyway.

Using the passive investment approach, investors simply buy a piece of the entire market instead of trying to make a call on which company or asset class will do better than another.

To accomplish this, an investor would buy a series of both equity and fixed-income index mutual funds or exchange-traded funds (ETFs) that replicate the performance of a market index, and simply hold them. Because ETFs generally track an underlying index, and therefore require no ongoing management, they are cheaper than mutual funds, with an average MER of 0.5% compared with 2.5% for actively-managed mutual funds. That means you put 2% more in your pocket, and you achieve diversification because you have bought the entire market.

“Active” passives?

But the ETF world is changing rapidly, with the introduction of smart-beta ETFs that track indexes designed to mimic various types of “active” characteristics, for example, mechanically weighting holdings according to earnings fundamentals, or estimations of future volatility, rather than by pure market capitalization as traditional index-tracking ETFs do. So are these types of ETFs “active” or “passive”? Are you buying what you believe to be a “passive” investment, but one with a higher risk ranking because of its “active” characteristics?

As you can see, there are investment risks associated with the passive approach, as there are with any investment strategy. Even with broad market indexes, if the markets drop steeply, your portfolio will drop right along with it.

The question is whether you believe that active managers can provide return over and above the market’s return after fees, or whether markets are in fact “efficient” and will outperform an active-management style over the long term. An entire investment industry has sprung up in which managers “actively” build portfolios consisting entirely of “passive” ETFs. This certainly reduces costs, but really fudges the line between “active” and “passive” investing strategies.

Being “actively passive”

If you select a passive approach, be prepared to stomach the full ups and downs of the market. If you choose an actively managed approach, be prepared to pay a higher fee, presumably for the stewardship of a professional money manager during periods of market turmoil.

Personally, I use both approaches, in what I call a passive base strategy with an active overlay. I make sure I have exposure to the broad markets, while adding a small active component in an attempt to capture what is called “alpha,” but is really just old-fashioned excess returns over market performance.

© 2015 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

© 2021 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.

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