Active vs Passive

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  • Topic: Active management, Investment, Collective investment scheme
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  • Published : October 25, 2010
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ACTIVE & PASSIVE PORTFOLIO MANAGEMENT

There are two basic approaches to investment management:

1. Active portfolio management is based on a belief that a specific style of management or analysis can produce returns that beat the market. 

o The active approach seeks to take advantage of inefficiencies in the market and is typically accompanied by higher-than-average costs (for analysts and managers who must spend time to seek out these inefficiencies). 

o Market timing is an extreme example of active asset management. It is based on the belief that it's possible to anticipate the movement of markets based on factors such as economic conditions, interest rate trends or technical indicators. Many investors, particularly academics, believe it is impossible to correctly time the market on a consistent basis. 

1. Passive portfolio management is based on the belief that: o Markets are efficient.
o Market returns cannot be surpassed regularly over time. o Low-cost investments held for the long-term will provide the best returns.

Stock Selection 

For those who favor an active management approach, stock selection is typically based on one of two styles:

• Top-down - managers who use this approach start by looking at the market as a whole, then determine which industries and sectors are likely to do well given the current economic cycle. Once these choices are made, they then select specific stocks based on which companies are likely to do best within a particular industry. 

• Bottom-up - this approach ignores market conditions and expected trends. Instead, companies are evaluated based on the strength of their financial statements, product pipeline or some other criteria. The idea is that strong companies are likely to do well no matter what market or economic conditions prevail.

Passive management concepts to know include:

• Efficient market theory - based on the idea that information that impacts the markets (such as changes to company management, Fed interest rate announcements, etc.) is instantly available and processed by all investors. As a result, this information is always taken into account in market prices. Those who believe in this theory believe that there is no way to consistently beat market averages.

• Indexing - one way to take advantage of the efficient market theory is to use index funds (or create a portfolio that mimics a particular index). Since index funds tend to have lower-than-average transaction costs and expense ratios, they can provide an edge over actively managed funds, which tend to have higher costs.

Active Management – Focus on Beating the Market

With an actively managed portfolio, a manager tries to generate investment returns that exceed the returns for a given benchmark index — also known as trying to beat the market.   

How is this done? 

The manager of such a portfolio selects individual securities to be a part of the investment basket. The active management position is that the various markets have pricing inefficiencies from time to time which create investment opportunities. The selection process is based on criteria and/or judgment of the manager, focusing on specific securities and the timing of trades. Typically, however, higher trading costs and turnover issues place actively managed portfolio costs (which eat into net returns) above passive management,

Proponents of active management believe that by picking the right investments, taking advantage of market trends, and attempting to manage risk, a skilled investment manager can generate returns that outperform a benchmark index.

For example, an active manager whose benchmark is the Nifty Index might attempt to earn better-than-market returns by overweighting certain industries or individual securities, allocating more to those sectors than the index does.

A manager might also try to control a portfolio’s overall risk...
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