The amount of research and press coverage about passive versus active investing has been unprecedented. If emerging investment flows are accounted for, the popular vote seems to be rather loud. Passive investments have been attracting a record-breaking amount of inflows, whilst active ones have been experiencing incremental outflows.
It is not the purpose of our brief article to provide a definitive answer to this long-standing question. We can, however, try to rationally address the individual modules that compose what seems to be an apparent dichotomy between these two investment approaches.
What is a passive investment strategy? Simply put (avoiding the academic principles behind it), it is a strategy that aims to closely track a broad market index via a market capitalization-weighted methodology for its constituent holdings. Investors are largely familiar with representative passive investment instruments, such as Index Funds and Exchange Traded Funds.
Any departure from the market capitalization-weighted index construction is, in principle, deemed to be characterized as an active investment strategy. Such an approach often involves a rules-based methodology, applied to the index constituents as well as a varying frequency of the index rebalancing. Investors are again aware of the vast wealth of active strategies, ranging from Smart Beta solutions to highly complex hedge fund strategies.
Passive investing is often presented as the domain for un-sophisticated investors, who speculatively chase returns for the lowest possible fee, by directly positioning their portfolio through passive index funds.
On the other hand, active managers are often presented as glorified, market benchmark-trackers who charge elevated fees and who, on average, provide no more than market beta instead of the well-sought-after alpha.
Are the above ‘popular‘ descriptions about both the definition of the investment strategies themselves and the practices of their managers accurate and representative of the way they could both contribute to an intelligent composition of a well-thought portfolio? Certainly not.
Neither is the perception that these two strategy approaches cannot co-exist complementary in a portfolio which seeks to tap into different sources of return and concurrently risk-adjust its positioning in a manner that will harness capital preservation.
What makes a strategy potentially passive or active is not only the weighting methodology or the frequency of its rebalancing.
It is also the way the systematic approach the manager utilizes which mainly determines: (i) when and by how much a portfolio repositioning should take place; (ii) when and by how much one should ride profits and cut losses; and (iii) when and by how much beta and alpha generating instruments should blend to provide proper diversification and risk-cautious return enhancement.
The answer to the above questions (and so many others) is: identification, measurement and management of Portfolio Risks.
Regardless of a manager’s methodology and style Active Risk Management can make the difference.
Portfolio management without an Active Risk Management element hardly differs from a simple security selection and may be catastrophic for an investor’s capital and wealth.
One should avoid discussions of semantics and instead focus on the substance that lies behind popular definitions.