Passive or Active? CII AF4, R02, J10

Examiners over the years have loved the “compare and contrast” type questions and students sitting the investment-based exams will sooner or later come across the thorny question of active versus passive investment management. 

The main passive techniques are:

Buy and hold – This technique does what it says on the tin, it buys stocks and holds them regardless of market conditions

Indexation – Indexation aims to replicate an index with no attempt to outperform it.

The four main types of indexation are:

• Full replication – buying every stock in the index
• Stratified sampling – buying a representative sample of the stocks in the index
• Optimisation – using a statistical model of the market to make buying and selling decisions
• Futures, forwards and swaps – synthesising the performance of the market using derivatives

Most managers will use a combination of these four techniques.

Arguments in favour of index tracking:

• The efficient market theory holds that all relevant information is available to investors at any given time and from US experience covering more than 20 years, most active managers don’t outperform their benchmark index on a consistent basis.
• The costs of running index tracking funds are generally less than for active funds

Arguments against index tracking:

• Guaranteed mediocrity – not possible to outperform by any degree, and likely to underperform after taking into account charges
• Actively managed funds can provide for a wide variety of different requirements that index tracking can’t
• Tracker funds can’t help but follow the index down
• Tracking concentrates the portfolio when constituent companies in the index merge

Active management

Active management introduces the human factor – the manager aims to use their skill to outperform the market. The main approaches are:

Top down  – Here the fund manager considers asset allocation first before sector and stock selection

Bottom up  – This approach selects individual stocks on their own merits – stock-picking.

The best and worst performing investment managers will usually be active managers. Many portfolio managers now use a mix of underlying actively and passively managed funds –The term ‘core-satellite’ portfolio is often used for a portfolio that is mainly indexed (it’s core) with actively managed, often specialist, funds around it (it’s satellite).