Portfolio Management Strategies, Styles and Techniques - 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 the following:
- Efficient market theory - This theory is based on the idea that information that affects 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 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 to 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.
Exam Tips and Tricks
Consider these sample exam questions:
The efficient market theory states that:
- future market prices are determined by the discounted value of future dividends.
- technical analysis tools cannot be used to beat the market, since current prices already reflect all available information about previous price patterns.
- current market prices already reflect all available information.
- market prices are determined by supply and demand.
The correct answer is "c" - "b" is incorrect because the efficient market theory is not concerned with technical analysis.
Passive asset management involves:
- using index funds as the investments for each asset class.
- choosing the stocks or mutual funds to be purchased for each asset class.
- buying securities for each asset class and holding them until the funds are needed.
- buying securities for each asset class and selling them when they reach their price targets.
The correct answer is "a" - while index funds are not a requirement of passive management, they are a frequently used tool. "C" is incorrect because passive management does not preclude making portfolio changes. For example, periodic rebalancing is performed, and changes can be made in response to changes in the client's risk tolerance, financial situation, goals, and so forth.