RSS FeedBy M. Isi Eromosele
Passive investors believe it is not possible to accurately identify investments that will consistently top market averages, at a low enough cost to justify the effort. Passive investors attempt to simply duplicate their respective investable universes.
Active investors believe that they are able to consistently identify enough high-performing investments to ultimately achieve better than average results. Active investors seek out what they consider to be better than average opportunities.
Advocates of passive investing believe the market behaves according to the efficient market hypothesis. The efficient market hypothesis states that prices are always fair and quickly reflect any new information that becomes available.
Advocates of active investing suggest that the market provides sufficient inefficiencies to be successfully exploited by the astute investor.
Comprehensive financial planning sets the very foundation for the financial future of investors. The active vs. passive management debate should only be addressed after a solid investment foundation has been built.
A solid planning foundation consists of goal identification, coordination of various financial planning aspects, development of an investment policy based on specific goals and risk tolerance. In the absence of a solid foundation, investors may lack the strength of conviction necessary to stay the course through a multitude of market cycles.
Tactical Allocation In Investing
Understanding the main drivers of portfolio returns is a major step in properly implementing an investment strategy. In order of their influence on results, these drivers are:
Strategic asset allocation investment policy between growth and fixed- income investments. This allocation should be based on each client’s unique objectives and risk tolerance. The policy allocation should be the foundation block of any long-term investment strategy.
Actively managed tactical allocation vs. a market neutral, static allocation. Significant value can be added (or detracted) by concentrating the portfolio in certain asset categories.
Selection of investments for each asset category may add (or detract) an additional layer of value.
A holistic approach based on the analysis of investors’ unique circumstances should provide a strategic investment policy on what percentage of a portfolio should be in growth/equity oriented investments and what percentage in fixed income.
Investment Selection - Passive Strategies
Passive investing presents some obvious advantages that are often publicized by indexing supporters.
Low cost - offers an incremental advantage that is both meaningful and certain. An active manager has to add enough value to overcome the cost disadvantage.
Reduced uncertainty of decision errors – investors are exposed to market risk simply by being invested. Reaching for returns in excess of those provided by the market brings about the additional risk of selecting the wrong investments.
Style consistency – If the appropriate indexes are selected, indexing, at least in theory, allows investors to control their overall allocation. Investors could only do this effectively through successful tactical allocation. There are no guarantees they will succeed.
Tax efficiency - Indexing is generally regarded as more tax efficient, though it is mostly the case for larger-cap indexes that are fairly stable and involve less trading. In smaller-cap indexes, where successful stocks grow in size and leave the index, tax liabilities resulting from more frequent rebalancings quickly accumulate.
Investment Selection - Active Strategies
The efficient market theory in its purest form strongly supports passive investing, as it dismisses the possibility for superior returns through investment selection. In reality, there are multiple market “anomalies” that do not support the efficient market theory.
Deeply rooted psychological biases negate the assumptions that all investors will act rationally. Passive strategies are also subject to certain natural biases, which may open the door to superior returns by active strategies.
Natural biases:
Large cap bias – Most indexes are market capitalization weighted. The largest holdings account for most of the return, causing indexes to out-perform active managers when large stocks do well, but under-perform when smaller companies are in favor. Historically, small companies have produced better returns than large ones.
Large market bias – The weighted nature of indexes also causes passive investors to maintain most investments in the largest markets. The largest markets are not necessarily the best performing. The over-emphasis on
Investment restrictions bias – Many large institutions are restricted by charter as to the types of securities they are allowed to purchase. Banks and insurance companies, for example, have many investment restrictions in building their bond portfolios. Such restrictions decrease market efficiency and leave openings to be exploited by opportunistic, skillful bond managers.
While there are no overall right or wrong answer to the active vs. passive management debate, there are a myriad of valuable observations that can be discerned.
While there are advantages and disadvantages to using both active and passive strategies, this debate should not be taken out of the context of investors’ goals and objectives.
It is also important to keep in mind that the tactical allocation decision ultimately influences the decision between active and passive management.
Although passive strategies may have an edge in very efficient areas of the market, active strategies may have an edge in less efficient areas. Both strategies will continue to co-exist in the industry because their relationship is symbiotic.
M. Isi Eromosele is the President |
Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control © 2012 Oseme Group
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