Active Strategy and Passive Strategy

2018-12-20 05:03
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Warren Buffet once said that, “Never depend on single income. Make investment to create a second source.” Many investors, especially beginner, may arise questions about investing, as well as how to invest. In fact, the purpose of investing in funds is to benefit from its quality of being professionally managed, with built-in diversification and is highly liquid. Although most investors have their own preference on investment style, mutual funds can optimize the portfolio of both active and passive investors. Investors who participate in fund investments could be categorized as one of the two styles: active strategy and passive strategy. Although we cannot weight one strategy above another, one strategy may better fit an individual depending on his/her preference and risk tolerance. This article explains the active strategy and passive strategy in details, the difference between the strategies, and how an investor can determine which strategy would be a better fit for him/herself.

What is Active Strategy?

Active strategy is also known as active investing, it represents investors who constantly monitor the movement of their portfolio and optimize the profitability of the chosen investment products several times a day. Active investing often requires a large team of professionals who conduct research on a large quantity of financial securities, retain profitable securities while removing unattractive ones, and determine the optimal timing to buy and sell each portfolio or fund. Some active investors may also prefer to maximize short-term returns while others prefer long-term growth instead. However, some financial institutes offer hands-on service directly from portfolio managers to handle each investor’s portfolio individually. These portfolio managers would always help to select portfolios based on the risk and return of financial products or select portfolios that outperform particular index, such as the Russell 1000 and the Standard & Poor’s 500 Index; Figure 1 represents three actively managed funds that outperform the Standard & Poor’s 500 Index as an example. Portfolio managers would constitute a broader analysis for active strategy because the experts observe the opportunities and risks frequently and always make decision for the transaction.

Figure 1

What is Passive Strategy?

Passive strategy is also known as passive investing, it represents investors who desires to increase wealth gradually by replicating their portfolio to market indices and avoiding frequent trading. Unlike active investing, passive investing utilizes the “Buy and Hold” strategy, by profiting from long term asset appreciation instead of the fluctuation of short-term price or market timing. Therefore, management team is not required to conduct research, analysis, or actively make investment decision for passive investors. Moreover, passive investing is required to have comprehensive research by the investor him/herself, because passive investors have to create well-diversified portfolios in order to closely track the returns of a particular market index or benchmark, such as Standard & Poor’s 500 Index and the ETF tracker, as shown in Figure 2.

Figure 2

Differences between Active Strategy and Passive Strategy         

Active strategy and passive strategy are undoubtedly very different, both having their own advantages and disadvantages. For the active strategy, flexibility is the most important elements that active investors fancy. The reason is under an active strategy, portfolio managers pursue a frequent trading style, as long as they believe the return can be maximized or will outperform the index. Secondly, since active strategy is managed by portfolio managers, therefore they constantly research and analyse economic data, market conditions, investment atmosphere etc, with the aim to help investors maximize the return or minimize the loss for the underlying investment. For the passive strategy, it attracts investors who prefer low expenses because the transaction costs are comparatively less than that of active strategy due to less trading frequency. Furthermore, passive strategy also has higher transparency as compared to active strategy because the portfolio’s holdings are mainly that of the underlying index’s constituent assets.

The disadvantages of active strategy are higher risk and expenses. The higher risk mainly comes from the fact that portfolio managers are trying to “beat the market”. Therefore, portfolio managers will inherently invest in riskier asset with the hope of achieving a higher return. The higher expense is apparent due to the fact that active strategy engages in more frequent trading, thus, incurring more transaction costs. As for passive strategy, the main disadvantages are its lack of flexibility and minimal alpha return opportunity.

An investor should have a clear understanding of his/her investment objective, investment horizon, risk tolerance etc before deciding which investment strategy would be better suited.

Which approach is better for you as an investor?

Figure 3 below presents the result of active strategy vs passive strategy for the past 32 years, which they were reversed. And also, the cyclical trend illustrates that no champion between two strategies.

Source: Hartford funds
Figure 3

 

However, a common question is under which market condition would cause active or passive strategy to outperform the other? From 1987 until middle of 2018, there were a total of 23 market corrections (a price decline of at least 10% of any security), which resulted in 18 times outperformance by active strategy, with an average outperformance rate of 1.41% as shown in Figure 4, while passive strategy only outperformed 5 times, with an average outperformance rate of 0.88% during that period. That is a surprising fact that market correction is the factor that helps active strategy to outperform.


Source: Morningstar
*Active Large Blend is made up of funds from the Morningstar Large Blend category that are not index or enhanced index funds.
* S&P 500 Index Funds is represented by the Morningstar S&P 500 Tracking Category.
Figure 4

For an investor to choose the suitable investment strategy is as much of an art as it is a science. The investment objective, investment horizon, risk appetite etc, can be very different from one investor to the next. So, for an investor to decide which strategy is suitable for him/herself, he/she may wish to consider the “F.E.A.R.” factor. “F” stands for Flexibility, that is, how flexible the investor could be when it comes to his investments, such as investment objective, asset choices etc. “E” stands for Expense, that is, how cost-conscious the investor is when it comes to the expenses for that particular investment. “A” stands for Achievement, meaning what the investor would like to achieve from his/her investment. Finally, “R” stands for Risk, representing the level of risk that the investor is willing to take.

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