Series 6

By Investopedia AAA

Evaluation of Customers - Portfolio Styles - Active vs. Passive

There are two basic approaches to investment management:

  • Active asset management is based on a belief that a specific style of management or analysis can produce returns that beat the market. It seeks to take advantage of inefficiencies in the market and is typically accompanied by higher than average costs (for analysts and managers who must spend time to seek out these inefficiencies).

  • Passive asset management is based on the concept that markets are efficient, that market returns cannot be surpassed regularly over time, and that low cost investments held for the long-term will provide the best returns.

For those who favor an active management approach, stock selection is typically based on one of two styles:

  • Top-down - managers who use this approach start by looking at the market as a whole, then determine which industries and sectors are likely to do well given the current economic cycle. Once these choices are made, they then select specific stocks based on which companies are likely to do best within a particular industry.

  • Bottom-up - this approach ignores market conditions and expected trends. Instead, companies are evaluated based on the strength of their financial statements, product pipeline, or some other criteria. The idea is that strong companies are likely to do well no matter what market or economic conditions prevail.

Passive management concepts to know include:

  • Efficient market theory - this theory is based on the idea that information that impacts the markets (such as changes to company management, Fed interest rate announcements, etc.) is instantly available and processed by all investors. As a result, this information is always taken into account in market prices. Those who believe in this theory believe that there is no way to consistently beat market averages.

  • Indexing - one way to take advantage of the efficient market theory is to use index funds (or create a portfolio that mimics a particular index). Since index funds tend to have lower than average transaction costs and expense ratios, they can provide an edge over actively managed funds which tend to have higher costs.
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