A Smooth Blend Of Active & Passive Investing

By:  Ian Maddox, CRPS™

When it comes to investing, there are countless strategies.  Some of these strategies come with fancy names like Arbitrage, Absolute Return, Market Neutral, Active, Passive—the list goes on.  Investment professionals and academics often argue the advantage of one approach over another.  A particularly heated debate, between two broad strategies, has run for the better part of thirty years: active management versus passive management.  Some of our readers might be familiar with this “investment lingo.”  However, for the benefit of our entire audience, let’s establish a few definitions.

According to Investopedia:

Active Management:The use of a human element, such as a single manager, co-managers or a team of managers, to actively manage an investment portfolio. Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell.

Passive Management: A style of management associated with investments that mirror a market index. Passive management is the opposite of active management in which an investment manager(s) attempt to beat the market with various investing strategies and buying/selling decisions of a portfolio’s securities.

Let me simplify further:  Advocates of Active Management seek (through brains) to outperform the market(s).  Those in the Passive Management camp let the market(s) do what they will.

A lot of time, energy and monies have been spent by academic and financial institutions working through the details of this debate. Here are a few things we know:

  • There are some really smart people in the world
  • People cost money—particularly those with a high IQ
  • Computers and indexing are efficient (i.e. cost less than people)
  • Computers and indexing can only do what they are programed to do

 

I think a simple chart might help in comparing the two strategies.  Here is a general breakdown of potential advantages/disadvantages of active vs. passive investing

[1]

[i] Advantages Disadvantages
Active Investments   Opportunity for outperformance Potential for underperformancePossible exposure to investments outside the scope of asset allocation guidelinesGenerally higher fees and tax costs
Passive (Index) Investments   Stay true to asset allocation guidelines through performance that seeks to track a benchmarkGenerally lower cost and greater tax efficiency No opportunity for outperformance

It seems there are advantages to both investment approaches.  Instead of choosing one strategy over another why not blend the two strategies into one  portfolio?  A dairy farmer would understand the metaphor, “To skim the cream.”  Why not leverage the best parts of each strategy, to the advantage of the investor, just like a farmer pulls cream from raw milk?  So, what should be considered the best parts, or the cream, of each strategy?  Or, more accurately, when, where, and with which asset classes could either strategy be used.

I won’t go through every possible asset class, but instead provide a specific example for blending active and passive strategy.  Let’s start with two asset classes, or more accurately, two subsets of a broad asset class (Stocks): large cap and small cap.  If an investor were to take the top ten large-cap equity portfolios and then look at the top-ten holdings in each of those portfolios, they might be surprised to find investment replication.  In other words, many of the portfolios might hold the same or similar investments.  What about small caps? A broad survey would reveal very little replication from portfolio to portfolio.  The reason for this is pretty simple.  There are many, many small companies and only a select few large companies in which a portfolio manager can invest.

So, if large cap-stock portfolios tend to look alike, (more like an index) than why pay for active management?  Passive or index investing will likely result in similar or identical investment return.  The analysis required to select small company investments, however, might very well justify the cost of hiring a professional management team.  This same “general” methodology can be applied to other asset classes.  We might lean towards passive or index investing when it comes to AAA, U.S. corporate debt, but employ an active strategy when dealing with the nuance and risk of selecting bonds issued in emerging market countries such as India, China or Brazil.

These examples apply today and will likely change over time.  For that reason, combining active and passive management in one portfolio creates more work for the wealth manager (or the individual investor, if they choose to do this on their own).  Not only must the allocation be analyzed and adjusted, but also how best to manage each individual asset class.  We believe the benefit justifies the extra effort.  Essentially, we are willing to pay for active management where active management has potential of outperformance and we lower the total portfolio costs through passive/index investing where outperformance is less likely.

 

[1] Figure 1 Leveraging the Strengths of Index and Active Investments, BlackRock ®

The prices of small cap stocks are generally more volatile than large cap stocks.

The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

No investment strategy assures a profit or protects against a loss. Investing involves risks, including possible loss of principal.

 

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