Rod Mackay Explains Active and Passive Investment Management

Active and Passive Investment management has long been the topic of debate on which is the better approach to a market. Rod Mackay explains the concept behind these two approaches for investors, their respective benefits and shortcomings, without taking a side.

The Concept

When an investor puts money into an investment fund using a manager, they are obliged to choose between two main strategies – active management or passive management.

Active Investment Management

Active management is speculative and seeks to outperform a market utilising the expertise of the manager, for example using research, analysis, and predictive techniques to ascertain market direction and volatility, and therefore when and what to buy and sell in the short term.

Passive Investment Management

Passive management is not speculative but invests in a market, and is driven by a belief that the performance of a market is simply the sum of the participating investments. Investors need a longer time horizon for growth, which generally outperforms active management volatility over the long term.

How it Plays Out

Rod Mackay points out that active management speculates on market anomalies, mispriced assets and misaligned market sentiment, in an attempt to produce an ‘alpha’ return, namely a value-added return above the market in general. For example, if the market rises, then an active manager will seek an even higher return in the short term. If the market falls, an active manager seeks to reduce the fall or even produce a positive return in the case of an absolute (greater than zero) return strategy, which intends to always be rising even when a market falls. This opportunistic approach typically plays out in the short term, perhaps minutes, hours, days or weeks.

Passive management investment, on the other hand, seeks to produce a ‘beta’ return which usually rises and falls with the overall market. For example, a passive strategy may simply duplicate a benchmark or index, which is a sample or subset of the market participants. Over time the market value is expected to grow with more rises than falls. Passive investment typically plays out over the long term, perhaps months and years.

Pros

Active Management

  • Flexibility: There is no specific approach, market direction or benchmark for active managers to follow.
  • Hedging: Active managers also have the option of hedging their positions by making use of various defensive mechanisms, like selling the downside risk, shorting or speculating on both rises and falls to minimise losses.
  • Diversification: Active managers are able to adjust to unexpected market movements by moving out of specific assets or subsectors to reduce risk without selling out completely.
  • Income: Often actively managed assets will produce frequent income while staying invested.

Passive Management

  • Growth: There is always the option to wait out market downturns. Assets usually grow with market activity over the long term with the effects of consumption, production, supply and demand, and can often ignore market volatility in the short term.
  • Larger Investments: Markets can usually accept much greater capitalizations (investment volume) of passive investments compared to speculative trading which is usually dependent on the volume.
  • Lower Fees: The value added by passive managers is simply to maintain the proportions of the investment to that of the benchmark or index. With no predictive component or high trading frequency the management fees are typically 1% pa and no performance fee.

Cons

Active Management

  • Higher Fees and costs: Active management has to pay for the expertise, increased activity and transaction costs of the trading. Typically, the manager will charge a higher management fee and also participate in the value-added performance if there is any. A 2% pa management fee and 20% performance is common.
  • Higher risk: The speculative and predictive character of active management means positions are always changing. They may outperform the market for a time, but then underperform as other active managers compete for the market opportunities, or they simply disappear with market movements.

Active Management

  • Exposure to market shocks: Large market corrections, long bear runs, and geo-political events can reduce passive investment value to an extend that taking a loss and starting again may be preferable than waiting for a recovery.
  • Longer Time Horizon: Typically, a longer time frame is required for passive growth which rises and falls with the market. Longer timeframes are more likely to experience adverse events.
  • No Income: Some passive investments can produce income, however a capital growth over the longer term is more common.

Exceptions to the Rule

Some investments can produce active management performance with passive management costs. For example, the Enhanced Land Fund and Premium Income Fund (both sub funds of The Guardian Investment Fund ARSN 168 048 057) invest in land and property development respectively. Both combine portfolio management with the natural accretive short-term growth of property development as an asset class. Both sub funds have a management fee of less than 2% pa and no performance fee.

 

Rod Mackay

Author Rod Mackay

More posts by Rod Mackay

Leave a Reply