Getting the most out of active and passive

Passive funds generally track an index or a basket of securities, and offer cost and tax benefits. Active managers try to beat the market indexes. To pursue such returns, investors are willing to pay higher fees to active managers for their level of expertise and market savvy.

The biggest downside for passive funds is that they don’t even attempt to manage investor risk.

When you “buy the market,” which is what an index does; you are buying its returns – both good and bad. Although they are more expensive, active funds are dynamic and provide the potential for benchmark-beating returns. Active management has the potential benefit of being thoughtful about which security and market risks are warranted and which are not. The index, however, makes no judgment of good versus bad. A key benefit here is that active funds may reduce the likelihood of having a portfolio of yesterday’s top performers. Active managers like to “buy low and sell high.”

When you buy an index, you may be doing the opposite at certain times. Of course, the biggest downside for active management is that at certain times it is tough to beat the market.

Because both passive and active strategies have advantages, the key is to achieve the appropriate balance between the two and create a durable portfolio: a diversified portfolio that is focused on risk management and that can withstand short-term market fluctuations.

So how should investors approach the issue? By taking into account five key points:
First, remember “alpha richness.” There is only so much excess return potential available to active managers at any given time. In 2014, for a recent example, active equity managers largely underperformed the market. Some market environments are more favorable to active; some are more favorable to passive. Also, some asset classes are more/less favorable to active/passive. That’s why blending both can be effective.

Second, keep in mind volatility and dispersion. Higher volatility is good for active managers relative to passive managers because they have the ability to manage risk. Dispersion within the market is good for active managers too because it increases the opportunity to find alpha between securities.

Third, achieve the right active share. Active share measures the percentage of an equity portfolio that differs from its benchmark. Active managers can only beat their benchmark and fees if their positions are sufficiently different from the index – an active share of 60 percent is adequate, while 80 percent is better and considered high active share. This is what the founders of the active share metric – Martijn Cremer and Antti Petajisto – set out to prove. They found that during the period between 1980 and 2003 (which they updated again through 2009), equity mutual funds with the highest active share outperformed their benchmarks, while those with lower active shares generally underperformed. High active share is a measurement that can make sure you don’t pay for active and get passive.

Fourth, think long-term. Active management requires more time and patience, and it’s important to identify the characteristics that tend to outperform over time. Since actively managed portfolios will endure periods of underperformance, having patience is key. These fluctuations are the price an investor pays for the chance at long-term excess returns.

Finally, remember that performance isn’t everything. Investments should not be made in isolation; what really matters when selecting a strategy is how it will fit into the overall portfolio.

Sometimes a simple index fund is the best option. At other times, an investor may want a specific style or mandate that can’t be replicated in an index. It may also be the case that the investor is more comfortable with a specific manager’s approach or method. When building a durable portfolio, sometimes selecting the “right strategy” is more important than picking the best-performing strategy.

In a dynamic global economy the risks and opportunities within the markets are constantly changing. It’s only common sense that “all-or-nothing” solutions (i.e., all active or all passive) will be sub-optimal. A truly durable portfolio should incorporate the advantages of both active and passive investments.