Knowledge Series Discussion Paper
4-box active-passive management
Investors often debate on whether a portfolio should have active or passive exposure to assets. Interestingly, the active-passive exposure is much more than just a binary choice. It actually falls into a 4-box matrix. In this discussion paper, we show how investors can adopt this 4-box matrix to active-passive management. Active management is a function of security selection and market timing factors. The portfolio manager of a diversified active fund, for instance, first selects securities within the investable universe of stocks. The manager then buys and sells these securities on a continual basis. The fund’s objective is to generate higher returns than the benchmark index. Such excess return is called alpha returns and is the reason why active funds charge higher management fees compared with passive funds. Passive management typically refers to index funds. The portfolio manager of such a fund simply takes exposure to pre-defined universe of securities constituting the index. Besides, the manager does not engage in market timing. The 4-box active-passive choice essentially separates the security selection and the market timing factors. Accordingly, active-active decision refers to active management (market timing) of active exposure (security selection). Passive-active decision refers to passive management of active exposure. That is, the investor actively selects securities and holds the portfolio till the investment horizon. Likewise, active-passive decision refers to active management of passive exposure, where the investor actively engages in market-timing her index exposure. Passivepassive decision refers to passive management of passive exposure. Active management is difficult and portfolio managers cannot consistently beat the benchmark index, despite possessing security selection and market timing skills. Alpha, in other words, is a zero-sum game. This means the excess returns of...
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