Lessons in Clarity: Active vs Passive Management

The active versus passive management debate is a heated one at many investment industry conferences. But what is the difference between the approaches and what are the considerations for the people behind the cash flows — that is, the investors?

In this article, we take a closer look at a key topic in the Investment Foundations course of study — active versus passive management (Module 7) — to understand these two approaches to investing.

Passive Managers

Passive investment managers are managers who are seeking to match the return and risk of an appropriate benchmark. Benchmarks can include broad market indexes (e.g., the FTSE 100, the S&P 500, and the Nikkei 225), indexes for a specific market segment (such as the Morgan Stanley Biotech Index, which focuses on the biotechnology industry), and even specifically constructed benchmarks.

For passive investment managers, a commonly cited measure of performance is tracking error, or the deviation (or difference) of the actual return on the portfolio from the return on the benchmark the manager set out to track. Because passive investment managers are trying to match the return of a benchmark, they can also be described as trying to minimize tracking error.

Passive managers may try to fully replicate the benchmark by holding all the benchmark’s securities or investments in proportions equivalent to their weighting in the benchmark. But many benchmarks are difficult and costly to fully replicate (sometimes because of the number of securities or because of availability issues), therefore instead of full replication, passive managers may hold some subset of the assets that is expected to closely track the benchmark’s return and risk. For example, a passive manager in the UK equity market might attempt to replicate the FTSE 100 market index by buying all 100 stocks or by selecting a subset of shares to represent each industrial sector of the market.

Active Managers

Active investment managers have a common belief that markets are not efficient and, therefore, that it is possible to outperform the market (and thus the benchmark).

The following are some common active management approaches. For example, instead of trying to replicate the entire index, like a passive manager, active managers may focus on selecting only the best individual securities or assets within an asset class. They may also try to time a market, which means buying when they believe the market is undervalued and selling when they believe the market is overvalued.

Active managers often try to identify and capture market inefficiencies through fundamental research. For equity investors, this process means conducting a detailed and thorough analysis of a company’s business model, its prospects, and its financial situation. This analysis may involve meeting with company management and interviewing them about their strategy and the prospects of the company. Some managers build statistical models that try to identify shares that are likely to outperform. By analyzing data, they identify characteristics that have typically been associated with share price outperformance.

Implications for Investors

Passive management is typically cheaper to implement than active management because successfully replicating or tracking a benchmark requires fewer analytical resources than researching and identifying investments with superior return potential does. Active approaches require a much more detailed analysis of each relevant investment or asset class, which is costly. Active management typically also has higher transaction costs because of more frequent trading in the portfolio.

Bottom Line

Now that you know the difference between the two approaches, you may still wonder what all the debate is about. Proponents of active management argue that good active managers can outperform the benchmark and, therefore, more than cover their costs and thus deliver net benefit to investors.

Conversely, proponents of passive management argue that the difficulty of identifying superior investments is such that it is not worth paying higher costs for that effort and that passive management will deliver higher net-of-costs returns over the longer term.