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Investment - Passive and Active Management
Beyond choosing on asset allocation, an investor must determine whether to utilize a passive or an active management strategy to asset selection.
Passive managers manage a portfolio designed to replicate the performance of a given benchmark.
Active managers aim to add value to a portfolio by selecting investments that are predicted, on the basis of analysis, to outperform a given benchmark.
The choice between the two approaches often rests on the relative costs of active management compared with passive management and on the investor’s expectation of the success of active management. The expectation is tied to the investor’s perceptions about the efficiency of the markets being invested in. An investor may elect to use a passive approach in some markets and an active approach in other markets based on an assessment of the efficiency of each market.
An informationally efficient market is one in which the prices of investments reflect available information about the basic values and return prospects of the assets they represent. For example, in a stock market environment, a company with outstanding prospects should have a high stock valuation, which indicates the future earnings that would likely accrue to the shareholders.
A corporation with bad prospects will have a low valuation to reflect the predicted low future profitability of the company. If stock markets are perceived to be informationally efficient, the investor will assume there is little reason to actively manage stock market investments because share prices already reflect the potential of the underlying companies. In other words, there is little to uncover via more inquiry. In contrast, in an inefficient market some shares may be over- or undervalued relative to the company’s prospects, and an investor may be rewarded with excess profits by properly identifying such shares.
Sometimes, whole markets — rather than simply individual shares — can be priced inefficiently. Some investors claim that stock markets in industrialized economies are reasonably efficient, but that those in emerging economies are less so. They claim that public information flows may not be as wide or accurate in emerging economies and that it is feasible for some investors to access and use information that is not available to others.
This condition could emerge because there may be less market regulation in emerging economies than in more developed economies or because there may be a dearth of experienced analysts researching markets in emerging economies. Similarly, some investors say that shares of smaller companies are less efficiently priced than shares of larger companies because fewer investors and analysts take the time to analyze tiny companies in detail, and information is less available. The most efficient markets tend to be those with a large number of active, informed members.
The marketplaces for such investments as real estate or private equity may not be efficient for numerous reasons. For instance, information on these investments may not be publicly available and trading is less active and done privately rather than on a public market in which prices and volumes may be observed. As a result, some investors may have access to information and transactions that are not available to other investors. In circumstances when inefficiency is known to exist, it is reasonable to expect that active management may be a successful solution.
PASSIVE MANAGEMENT
Passive investment managers strive to match the return and risk of a benchmark. Benchmarks include broad market indexes, indices for a specific market segment, and specifically developed benchmarks. Passive investment managers seek to limit tracking inaccuracy. The tracking error is the deviation of the return on the portfolio from the return on the benchmark being monitored. Passive managers may strive to fully replicate the benchmark by holding all the securities in the benchmark in amounts equivalent to their weighting in the benchmark.
ACTIVE MANAGEMENT
Active investment managers utilize a range of approaches. They may attempt to identify assets that will outperform the benchmark. These active managers focus on selecting specific shares or assets in an asset class or classes. Active managers may also try to timing a market (buying when they believe the market is low and selling when they believe the market is overvalued). Tactical asset allocation is an example of trying to time markets.
Factors Needed for Active Management to Be Successful
Active management is a tough endeavor, yet there are managers that have excellent long-term records of accomplishment. For active managers to be continuously successful, they have to be better than ordinary investors at appraising the potential of investments. When active managers buy a security or investment because their analysis suggests it has strong return potential, they may be buying it from another active manager who believes the prospects for the asset are poor.
For active managers to find outperforming stocks on a consistent basis, they must either have access to better information than other investors or be able to respond and use the same information faster or with better models to interpret the information. The capacity to accomplish this is tough because so many other investors have access to the same information and tools.
In many markets, corporate disclosure requirements ensure that information about company fundamentals must be made available to all investors at the same time. In reality, rules often restrict selective sharing of key information on corporate prospects or performance. As mentioned in Course 1, Industry Overview and Structure, investors trading based on material nonpublic information — known as insider trading — face serious legal and criminal implications in most jurisdictions.
Also, for active management to be successful, any mispricing of investments has to be big enough to offset the costs of exploiting the mispricing. Investing in an undervalued security is only worthwhile if the excess return covers the cost of the research required to find the undervaluation and the trading fees involved in investing in the investment. Accurately forecasting mispricing is challenging since prices normally should already represent most publicly available information regarding basic values.
Much academic and practitioner research has shown that most active managers do not regularly outperform the market over lengthy time periods, even accounting for fees and expenses. Unfortunately, identifying active managers who will exceed the market in the future is generally as difficult as predicting specific assets that will outperform the market.
Choosing between Passive and Active Management
Is investing passively in an index, such as the Hang Seng Index, the S&P 500 Index, or the FTSE 100 Index, the greatest method to enhance your wealth? Or is hiring an active investment manager with a record of past performance a better option? Unfortunately, it is never possible to tell for sure in advance. But the choice between passive and active management is a major problem for investors and the decision must be evaluated carefully.
Passive management is often cheaper to adopt than active management since properly duplicating or tracking a benchmark takes fewer analytical resources than researching and discovering investments with greater return potential. The passive strategy involves some ability, such as determining which investments to include in the benchmark and their corresponding values and weights in the benchmark. Although the costs of passive management are lower than the expenses of active management, the return achieved by the passive investor will often be less than the index return because of costs.
Passive management of equity portfolios is a well-established discipline and duplicating an equity market index is very uncomplicated. But for some markets, like as real estate, in which all properties are unique and trading is done in private transactions rather than on a public stock exchange, it is less clear how a passive method may be applied. There may not be a suitable index for passive managers to track.
In addition, real estate assets themselves have to be managed (kept, rented, remodeled, and so on) in a way that stock investments do not. So, most investments in real estate are actively handled to some level. A same reasoning applies to private equity and venture capital.
Active techniques involve a more extensive investigation of each relevant investment or asset class, which is costly because investment firms need skilled workers and/or expensive technology. Active management often also has higher transaction costs because of more frequent trading in the portfolio. If active management does generate returns that are higher than the benchmark, the excess return may compensate for the increased employee, technology, and transaction costs and the net returns to the investor may be higher.
Proponents of active management say that good active managers can more than cover their expenses and hence give net benefit to investors. Conversely, proponents of passive management say that the difficulty of discovering superior investments means it is not worth paying greater fees for that effort and that passive management will give higher net-of-costs returns over the longer run. Concerns about the costs, the average or below-average performance of most active managers, and the difficulties of finding active investment managers who may succeed in the future have made passive investment techniques increasingly popular over time.
Despite these concerns, active management nonetheless remains popular.
As indicated previously, an investor may elect to use a passive approach in some markets and an active approach in other markets depending on an assessment of the efficiency of each market.
Beyond choosing on asset allocation, an investor must determine whether to utilize a passive or an active management strategy to asset selection.
Passive managers manage a portfolio designed to replicate the performance of a given benchmark.
Active managers aim to add value to a portfolio by selecting investments that are predicted, on the basis of analysis, to outperform a given benchmark.
The choice between the two approaches often rests on the relative costs of active management compared with passive management and on the investor’s expectation of the success of active management. The expectation is tied to the investor’s perceptions about the efficiency of the markets being invested in. An investor may elect to use a passive approach in some markets and an active approach in other markets based on an assessment of the efficiency of each market.
An informationally efficient market is one in which the prices of investments reflect available information about the basic values and return prospects of the assets they represent. For example, in a stock market environment, a company with outstanding prospects should have a high stock valuation, which indicates the future earnings that would likely accrue to the shareholders.
A corporation with bad prospects will have a low valuation to reflect the predicted low future profitability of the company. If stock markets are perceived to be informationally efficient, the investor will assume there is little reason to actively manage stock market investments because share prices already reflect the potential of the underlying companies. In other words, there is little to uncover via more inquiry. In contrast, in an inefficient market some shares may be over- or undervalued relative to the company’s prospects, and an investor may be rewarded with excess profits by properly identifying such shares.
Sometimes, whole markets — rather than simply individual shares — can be priced inefficiently. Some investors claim that stock markets in industrialized economies are reasonably efficient, but that those in emerging economies are less so. They claim that public information flows may not be as wide or accurate in emerging economies and that it is feasible for some investors to access and use information that is not available to others.
This condition could emerge because there may be less market regulation in emerging economies than in more developed economies or because there may be a dearth of experienced analysts researching markets in emerging economies. Similarly, some investors say that shares of smaller companies are less efficiently priced than shares of larger companies because fewer investors and analysts take the time to analyze tiny companies in detail, and information is less available. The most efficient markets tend to be those with a large number of active, informed members.
The marketplaces for such investments as real estate or private equity may not be efficient for numerous reasons. For instance, information on these investments may not be publicly available and trading is less active and done privately rather than on a public market in which prices and volumes may be observed. As a result, some investors may have access to information and transactions that are not available to other investors. In circumstances when inefficiency is known to exist, it is reasonable to expect that active management may be a successful solution.
PASSIVE MANAGEMENT
Passive investment managers strive to match the return and risk of a benchmark. Benchmarks include broad market indexes, indices for a specific market segment, and specifically developed benchmarks. Passive investment managers seek to limit tracking inaccuracy. The tracking error is the deviation of the return on the portfolio from the return on the benchmark being monitored. Passive managers may strive to fully replicate the benchmark by holding all the securities in the benchmark in amounts equivalent to their weighting in the benchmark.
ACTIVE MANAGEMENT
Active investment managers utilize a range of approaches. They may attempt to identify assets that will outperform the benchmark. These active managers focus on selecting specific shares or assets in an asset class or classes. Active managers may also try to timing a market (buying when they believe the market is low and selling when they believe the market is overvalued). Tactical asset allocation is an example of trying to time markets.
Factors Needed for Active Management to Be Successful
Active management is a tough endeavor, yet there are managers that have excellent long-term records of accomplishment. For active managers to be continuously successful, they have to be better than ordinary investors at appraising the potential of investments. When active managers buy a security or investment because their analysis suggests it has strong return potential, they may be buying it from another active manager who believes the prospects for the asset are poor.
For active managers to find outperforming stocks on a consistent basis, they must either have access to better information than other investors or be able to respond and use the same information faster or with better models to interpret the information. The capacity to accomplish this is tough because so many other investors have access to the same information and tools.
In many markets, corporate disclosure requirements ensure that information about company fundamentals must be made available to all investors at the same time. In reality, rules often restrict selective sharing of key information on corporate prospects or performance. As mentioned in Course 1, Industry Overview and Structure, investors trading based on material nonpublic information — known as insider trading — face serious legal and criminal implications in most jurisdictions.
Also, for active management to be successful, any mispricing of investments has to be big enough to offset the costs of exploiting the mispricing. Investing in an undervalued security is only worthwhile if the excess return covers the cost of the research required to find the undervaluation and the trading fees involved in investing in the investment. Accurately forecasting mispricing is challenging since prices normally should already represent most publicly available information regarding basic values.
Much academic and practitioner research has shown that most active managers do not regularly outperform the market over lengthy time periods, even accounting for fees and expenses. Unfortunately, identifying active managers who will exceed the market in the future is generally as difficult as predicting specific assets that will outperform the market.
Choosing between Passive and Active Management
Is investing passively in an index, such as the Hang Seng Index, the S&P 500 Index, or the FTSE 100 Index, the greatest method to enhance your wealth? Or is hiring an active investment manager with a record of past performance a better option? Unfortunately, it is never possible to tell for sure in advance. But the choice between passive and active management is a major problem for investors and the decision must be evaluated carefully.
Passive management is often cheaper to adopt than active management since properly duplicating or tracking a benchmark takes fewer analytical resources than researching and discovering investments with greater return potential. The passive strategy involves some ability, such as determining which investments to include in the benchmark and their corresponding values and weights in the benchmark. Although the costs of passive management are lower than the expenses of active management, the return achieved by the passive investor will often be less than the index return because of costs.
Passive management of equity portfolios is a well-established discipline and duplicating an equity market index is very uncomplicated. But for some markets, like as real estate, in which all properties are unique and trading is done in private transactions rather than on a public stock exchange, it is less clear how a passive method may be applied. There may not be a suitable index for passive managers to track.
In addition, real estate assets themselves have to be managed (kept, rented, remodeled, and so on) in a way that stock investments do not. So, most investments in real estate are actively handled to some level. A same reasoning applies to private equity and venture capital.
Active techniques involve a more extensive investigation of each relevant investment or asset class, which is costly because investment firms need skilled workers and/or expensive technology. Active management often also has higher transaction costs because of more frequent trading in the portfolio. If active management does generate returns that are higher than the benchmark, the excess return may compensate for the increased employee, technology, and transaction costs and the net returns to the investor may be higher.
Proponents of active management say that good active managers can more than cover their expenses and hence give net benefit to investors. Conversely, proponents of passive management say that the difficulty of discovering superior investments means it is not worth paying greater fees for that effort and that passive management will give higher net-of-costs returns over the longer run. Concerns about the costs, the average or below-average performance of most active managers, and the difficulties of finding active investment managers who may succeed in the future have made passive investment techniques increasingly popular over time.
Despite these concerns, active management nonetheless remains popular.
As indicated previously, an investor may elect to use a passive approach in some markets and an active approach in other markets depending on an assessment of the efficiency of each market.
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