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Active Versus Passive Investing Strategies

In the world of investing there is a long standing debate between the merits of active management and passive investing. Academic research tends to support passive investing; the arguments against tend to come from the major investment dealers, the large banks, insurance companies, mutual fund companies and active money managers, who all reap huge profits from active management.

We are not going to get into the debate, but are going to compare, in very general terms, these two approaches to investing.

Active Investment Management

Active managers believe that they can add value by their ability to pick securities which on average will outperform their benchmark. There are literally hundreds of methods that are used by active managers to attempt to uncover those securities which will outperform. These methods include fundamental analysis, technical analysis, economic analysis etc… Active management is the predominant form of money management today.

Passive Investment Management

Passive investment management assumes that it is very difficult to outperform the market, therefore just invest in the overall market. It is called passive, because managers do not make decisions about which securities to buy and sell. They will simply mirror the index. Since the advent of Index mutual funds and Exchange Traded Funds (ETFs), individual investors can now buy broad sectors of the market.

Asset Mix Allocation and Security Selection

In investing there are two major decisions: what is the asset allocation of the overall portfolio? and what securities belong in each asset class. For each decision, an investor can take either an active approach or a passive approach.

Passive Asset Allocation, Passive Security Selection

This is the simplest of all strategies. In this strategy, an investor picks a long term or strategic asset mix that is appropriate for their financial goals and risk tolerance. The asset mix is rebalanced occasionally to ensure that the long term asset allocation is maintained. Index funds or ETFs would be purchased to represent the underlying asset classes. (See the Perfect Portfolio – How to get an A in Investment Management for an example.) This is a strategy for investors who are not interested in the day to monitoring of the markets and feel that they are unable to add value in either asset mix or security selection.

Active Asset Allocation, Passive Security Selection

In this strategy investors will adjust their asset mix from their long term asset mix depending on their overall views of the markets. If an investor believes that stocks are going to outperform in the short term, then he might overweight the equity asset class in his portfolio. Another name for active asset allocation is tactical asset allocation. Like the previous strategy, index funds or exchange traded funds (ETFs) would be purchased to represent the underlying asset classes. This is a strategy that might be appropriate for those investors that take a top down approach to investing in the market, but with little interest or skill in security selection.

Passive Asset Allocation, Active Security Selection

In this investment strategy, an investor would pick a long term or strategic asset mix that is appropriate. The asset mix would be rebalanced occasionally to ensure that the long term asset allocation is maintained. For each asset class, individual securities would be purchased with belief that the investor will beat the underlying benchmark. This is a strategy for stock pickers who believe they can outperform the stock market with their skills in stock selection. They might have little interest or skill in tactical asset allocation.

Active Asset Allocation, Active Security Selection

In this strategy, investors will adjust their asset mix from their long term asset mix depending on their overall views of the markets. If they believe that stocks are going to outperform in the short term, then they might overweight the equity asset class in their portfolio. For each asset class, individual securities would be purchased, with the belief that they will beat the underlying benchmark. This strategy might be appropriate for those investors that take a top down approach when they are investing in the market, but also believe they have superior stock picking skills.

Combining Passive and Active Strategies

Many investors will actually combine active and passive strategies within their portfolio. For example, a Canadian investor might buy individual securities for the Canadian part of their portfolio and then purchase ETFs for exposure to the U.S. and global stock markets. Alternatively they can combine an active and passive strategy within one asset class. For example, an investor might have 50% of his Canadian portfolio in an ETF and 50% in individual securities. This approach is called “Core and Explore” or Core/Satellite. This approach will be discussed in “10 Reason To Use A Core and Explore (Core/Satellite) Investment Strategy”.

Conclusion

The approach an investor takes in determining which part of his portfolio will be managed actively and which part of his portfolio will be passively managed is dependant on his skills and confidence. If an investor believes he has the skills to outperform, then that part of the portfolio should be actively managed. If however, the investor believes that he cannot outperform or add value, then that part of the portfolio should be passively managed. Investors should concentrate on those areas of their portfolio where they can add the most value, and still get proper diversification in the other part of their portfolio by using low cost ETFs.