In a market timing approach, the portfolio manager seeks maximum capital gain by opportunistically switching assets between cash and the market. This is an attempt to buy securities when they have decreased in price and then sell them when their prices rise. Empirical evidence tends to refute the longer term merits of such a strategy as it can entail frequent and costly trading which is often ill timed and erodes returns. Few investors, be they professional or amateur, are able to achieve success for any appreciable length of time with this approach as a result.
Passive investing utilizes index mutual funds and exchange-traded funds to gain exposure to various segments of the market. Underscoring this approach is the investor's belief that the financial markets are, for the most part, efficient, and, therefore, rather difficult, if not impossible to outperform. Passive investing can focus on the overall market as well as various segments of it.
The proliferation of exchange traded funds would seem to enable investors to gain cost-efficient exposure to any number of market styles and segments. The benefit of passive investing is its cost-efficiency. Active management involves use of the manager's investment acumen which may or may not be on target and which is more expensive as trading securities is involved. Because such an approach takes what the market has to offer, some pundits would decry what they deem as its blind faith in the efficient market theory, which holds that markets are random and that the surfeit of active management often makes the pursuit of alpha a fruitless exercise.
Additionally, the plethora of ETFs allows investors to gain rapid and inexpensive exposure to various equity and fixed income market segments, as well as to sectors and industries. Investors would do well to understand just what it is that these funds are attempting to replicate and the risk/return trade off of doing so. Some segments of the markets are less efficient than others. Investors should not rely upon passive investing as a panacea for the pursuit of various objectives.
Buy and Hold
A type of passive strategy, the buy and hold approach involves little more than purchasing a mix of assets and holding them.[Perold, André F. and Sharpe, "William F. Dynamic Strategies for Asset Allocation", Financial Analysts Journal, January/February 1988 p. 17]. The portfolio is not rebalanced. To the extent that the portfolio is invested in equities, the potential for price appreciation is unlimited in a rising market. In down markets, this approach will experience less growth, but be cushioned to the extent that it is invested in fixed income and cash. As this approach involves no trading beyond the initial purchases, it is passive and inexpensive.
Immunization is a fixed-income strategy designed to address interest rate risks, ensuring that the portfolio maintains a yield sufficient to meet any liabilities as they come due. The change in yield can result from a change in market interest rates, either increasing or lowering the value of the portfolio in consequence and possibly hindering the portfolio's ability to satisfy its obligations. Effective immunization entails matching the portfolio's duration to the length of the investment horizon, and making the present value of the cash flow from the fixed income instrument equal that of the future liability.[Fabozzi, Frank J. Bond Markets, Analysis and Strategies, Second Edition Prentice Hall, 1993 Chapter 22 Structured Portfolio Strategies p.535 "To immunize a portfolio's target accumulated value against a change in the market yield, a portfolio manager must invest in a bond (or a bond portfolio) such that (1) the Macaulay duration is equal to the investment horizon, and (2) the initial present value of the cash flow from the bond (or bond portfolio) equals the present value of the future liability."] Bonds are purchased with varying maturities, both lesser and greater than the time horizon of the investor. Rebalancing would need to occur semi-annually to annually. Defined benefit retirement plans utilize immunization to meet the cash flow needs of retirees. The strategy is imperfect, as the conditions for immunization assume a flat yield curve and parallel changes in it (e.g. interest rate increases or decreases are in equal measure in terms of basis points).
Swap and Collar Strategies
InvestingFind out how these strategies work and how you can put them to work for you.
InvestingWhenever we talk about the asset-liability approach to portfolio management (ALM), the concepts of immunization and cash flow matching come into play.
RetirementLearn about the differences between active and passive investing for those approaching retirement. Discover how passive investing is gaining popularity.
Financial AdvisorPortfolio planning has never been more important or more daunting for investors. Find out the steps involved in the portfolio planning process.
InvestingPortfolio investment involves buying securities with the expectation of earning a return on them.
InvestingFind out how this approach reduces risk and costs so you can maximize your portfolio's return.
Financial AdvisorAchieve analytical efficiency by applying your evaluation to a key set of stocks.
Managing WealthDedicated Investment Portfolio strategies have been used by institutional investors like pension funds and insurance companies for many years and have gained some popularity with individual investors ...
Financial AdvisorLearn how an increase in the federal funds rate may impact a bond portfolio. Read about how investors can use the duration of their portfolio to reduce risk.