Equity portfolio management includes passive management and active management. This two type of management are different in theory, objective and strategy. Some argue that “hybrid” active/passive equity portfolio management styles exist, but such styles really are variations of active management philosophies (Brown, and Reilly, 2012). In this article, firstly, we will define active and passive management and discuss about the differences between these. Secondly, we will talk about the strategies of active and passive management with some example. Thirdly, we will analysis two managements’ advantages and disadvantages with some examples. Finally will be a recommendation of management style choosing.
Active management “refers to a portfolio management strategy where the managers make many specific investments with the goal of outperforming an investment benchmark index (Fuller, Han, and Tung, 2010)” The aim of active management is to deliver a high return in the whole market. In another way to say, it aims to beat the return from a particular market index or benchmark (Vanguard, 2012). Investors could choose an adapt opportunity to adjust the portfolio, which could achieve the maximum profit and minimum risk. The active management is based on the assumption of inefficiency market; the debenture always has the correctness of pricing when the interest rate changed.
Active management also depend on the human element, such as team managers, the single manager or co-managers, which could operate the portfolio with a convenience, efficiency and flexible way (Loth, 2014). The human element could depend on the current market to analyse, judge and forecast the debenture with their own experience; they know the time, when will buy or sell. Moreover, active management does not believe the efficient market hypothesis, managers believe that the market always has some incorrect price and other leaks, which is unconscious; they could use these leaks to maximum the profit.
Passive management “is a financial strategy in which a fund manager makes as few portfolio decisions as possible in order to minimize transaction costs, including the incidence of capital gains tax. One popular method is to mimic the performance of an externally specified index (Fuller, Han, and Tung, 2010)”. The goal of a passive portfolio is to match the returns to the index as closely as possible (Brown, and Reilly, 2012). This management believe the efficiency market hypothesis; it determines that the time line of market could reflect all the information, some specific stock pick will be fail, and the best strategy of investing is based on the index. (Loth, 2014) the passive management just follows the market, and have a less charge, all the data of stocks will be analyzed by the computer, and show to the investors. When the investors uses the passive management, it is that the investors do not care about the good performance of specific stock, they focus on the whole stocks have a good performance, and get the profit. Investors need collect all the stocks and bonds to achieve an excellent return. (Anspach, 2014)
In conclude, an active decision could be thought as an investor making choices among many possible choices in order to create a portfolio. Passive investing is commonly viewed as not involving very many, if any, active decisions or arbitrary choices in the investment process.
Active management strategies include fundamental, technical and asset allocation strategies.
Fundamental strategies include the ‘Top-Down’ and ‘Bottom-Up’ approach. Top-down approach means that managers could start looking at the market as a whole, and then determine which industries or sectors are likely to do well given the current economic cycle. When the choice has made, the selection of specific stocks will be possible to have a best for a company. The Bottom-up has ignored the market conditions and expected return. Companies are based on the financial statement, product line, P/E, Growth and others to evaluate themselves, this approach means that the well-running companies will have a good performance, no matter what market conditions and expected return. (Loth, 2014)
Secondly, Technical strategies means that the charts or grapes could determine the direction of stock, investors could depend on these direction to buy or sell. It could show the market is bull or bear, determine the time of buying or selling, and forecast the trend of stocks. Such as the Moving average, which is 50 days and 100 days, when the line of 50 days over the line of 100 days, this is a sign of buying, which means that the price of stocks will increasing in the future, or reverse. Contrarian investment strategy means that investors could buy some poor performance stocks, and sell them when these stocks have good performance. The price momentum strategies means that the good performance stocks will maintain a while, investors could buy these stocks, and sell them when these stocks get better. The earnings momentum strategies means when the earning per share of a company is increasing, then the sales or other index will increasing, investors could depend on this way to buy stocks, which get the profit.
The last on is the asset allocation strategies, which include the integrated asset allocation, strategic asset allocation, tactical asset allocation and insured asset allocation. The strategic asset allocation means that investors could hold the stocks and bonds as their asset, such as if an investor hold 50% stocks and 50% bonds, which has historical 10% and 5% return per year, then the total return of asset will be 7.5% per year. The tactical asset allocation could be a short-term; investors could continually adjust the asset to adapt the changing market. This way is flexible, which could fit for the different market situation. The insured asset strategy means that the portfolio of investors should have a basic return, if the portfolio achieves the basic return, the investors should increase the management, and achieve the maximum return. If the portfolio maintains the basic return, the investors will have a riskless asset. The investors and managers could change the weight of asset, and over the basic return. Integrated asset allocation could examine the capital market conditions, investor’s objectives and constrains, this considers the economic expectation and the risk when the investors establish the mix asset, could not only consider the expectation, but also the actual change in capital market. It analyses the ability of risk tolerance. Investors could depend on the actual market situation to make the decision for changing mix asset or improve the mix asset.
For the strategies of passive management, it is index portfolio strategy, which include the full replication, sampling and quadratic optimization. Full replication means that the managers could purchase by the weight, which is similar with the index, which could be easy to track the index.
The sampling means that ETF could provide a lot of pure physical replication, therefore, using the sampling techniques could be a good way to find a adapt index, in general, fund could utilize sampling to choose the index, and weighting. Such as the MSCI world index has more 1,600 sticks, buying all stocks is impossible, and inefficient, using sampling to choose a small weighting could achieve the correct target. Moreover, sampling is a cheap and statistical way, through buying the sample stock could know the weight in index. A small number of stocks could determine that the charge is less, fewer problem of reinvestment, and less difficult for rebalance. (Hughes, 2014)
The quadratic optimization could comfirm the mix investing, which depend on the historic data and relevant information. This way could significantly decrease the tracking error for the index. The market will change with the time, which may cause the incorrect index. The formula is, the tracking error could be determined by . Therefore, investors could reply on this way to minimum the error of tracking index.
Through the comparison of passive and active management, investors could directly know when they should use the passive or active management, or how to use them.
The passive management has some advantages, the investors have a lower fees, they do not need to analyse the stocks in the index, and it has transparency, investors know the time to buy or sell some kinds of stocks, moreover, the hold and buy of index fund will not large tax, because of the limited investing amount. The tax efficiency is high. The passive investor also could avoide the challenges and costs, which associate with the active managers. In the complex world, the smartest people also could stumble, and go to trouble. Beating the market is a difficult thing.
However, passive management require the investors accept the configuration of indexes, no matter how risk holding and inherent. The S&P 500 is managed by a committee which considers many factors, such as market capitalizations, sector representation, liquidity and positive earnings; holdings are adjusted regularly. By contrast, the Russell indexes has a rule per year, which is “to ensure new and growing equities are reflected.” Poor performance Companies, in some cases, can be a material portion of a Russell index. In the case of bonds, some indexes do not account for defaults until they occur and occasionally contain illiquid securities (Whitehead, 2012)
The passive management also will assumes a significant weighting to individual securities. The stocks will be larger, the money is valued by market capitalization in the indexes, which lead to the emphasis on some good performance companies or industries, forcing them to undertake the risks. Such as, over 30 percent of the S&P 500 was invested in the energy sector in the 1970s and in technology and telecommunications in the 1990s, and 20 percent in financials, then in few years, the collapse of those sectors was because of large cap passive portfolios. For individual companies, passive management expose investors’ risks. For example, Nortel accounted occupy 36 percent in the Toronto Stock Exchange’s main index in 2000, then its market capitalization dropped from $250 billion to less than $50 million, and bankruptcy in January 2008. Likewise, the top five mega-stocks occupy one-third of the loss in the S&P 500 when the technology bubble burst in 2000. Therefore, the index may cause a significant risk. (Whitehead, 2012)
For the advantage of active management, firstly, there is an opportunity for outperformance in active management as it aim to beat the index. Active management is flexible, which is different with the passive management, not require hold specific stock or bond. The hedging is also important, which managers could use short sales and put option to protect the investors minimum the losses. The investors could go out the specific holding risk, moreover, the active management could maintain the investors have a stable investing strategy and principle, higher average level record, and restrict risk management.
For the disadvantage of active management, active management have a significant pressure, when the manager operate the investing, these mangers afraid the failure, they are always cooperation each other, they are investing defensively and avoid big error. The active management also will have relevant risk, such as the loss of personnel or clients, lagging performance, out-favour of strategy or style. The change of investing principle will lead to change of ownership.
The manager of active management maybe more useful in specialised areas, such as the technology, smaller companies and the emerging market. Passive management is suitable for the easy trade, such as Smetters, people has known this company that active managers are unlikely to gain any special insight.
In my recommendation, the passive management is better than active management. This result is depend on the investor’s behaviour, current stock market, manager’s attitude and lower risk. Moreover passive management has lower charge, and convenience, investors could depend on the index to adjust their asset, and buying stocks. In recently, the active managers has a negative attitude, they afraid the fail, and be negative to make decision. Therefore, the passive management is better.
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