What is the difference between passive and active asset management? (SPY)
Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and passive asset management. Active asset management focuses on outperforming a benchmark, such as the S&P 500 Index, while passive management aims to mimic the asset holdings of a particular benchmark index.
Investors and portfolio managers who implement an active asset management strategy aim to outperform benchmark indexes by buying and selling securities, such as stocks, options and futures. Active asset management involves analyzing market trends, economic and political data, and company specific news. After analyzing these types of data, active investors purchase or sell assets.
Active managers aim to generate greater returns than fund managers who mirror the holdings of securities listed on an index. Generally, the management fees assessed on active portfolios and funds are high.
Contrary to active asset management, passive asset management involves purchasing assets that are held in a benchmark index. A passive asset management approach allocates a portfolio similar to a market index and applies a similar weighting as that index. Unlike active asset management, passive asset management aims to generate similar returns as the chosen index.
For example, the SPDR S&P 500 ETF Trust (SPY) is a passively-managed fund for long-term investors that aims to mirror the performance of the S&P 500 Index. The manager of SPY passively manages the exchange-traded fund (ETF) by purchasing large-cap stocks held in the S&P 500 Index. Unlike actively-managed funds, SPY has a low expense ratio due to its passive investment strategy and low turnover ratio.
Active asset managers, with the exception of some not-so-good ones, perform extensive analysis on companies' financials, analyze their balance sheets to assess their capital position and the value of the business as a going-concern (versus its liquidation value, or the value that could be received if all assets were liquidated and sold); they meet regularly with company management teams to assess the companies' strategic plans, corporate governance practices, and executive (C-Suite) incentives (based on things such as their incentive compensation plans, bonus structures, salaries, sales/earnings targets required to earn different bonus levels). They also study the composition of the Board, seeking outside, non-executive independent directors and those who have experience particular to the industry in which the company operates. They prepare detailed valuation models, with their own forecasts for future cash generation to develop a fair assessment of value, within range.
I probably don't need to tell you this, but a company with excessive gearing (leverage) and high interest costs eating into their cash flows and declining earnings is less attractive relative to one trading at roughly the same valuation multiples that is growing sales and earnings, has higher margins and relatively low debt.
When you invest in an active manager, he/she has a team of analysts speaking with other industry experts to evaluate the prospects for the industry in which the company operates, assess its competitive edge and whether this is sustainable, evaluate supplier and customer relationships, and more.
Active managers obviously have to charge a relatively small-fee for doing all this work, generally about 1.5% on the total money (or "assets under management" or "AUM") invested in the fund.
On the other hand, passive index-based investing just throws money at a bunch of stocks, regardless of their future prospects, speculating that the stock market will continue to rise and thus they will not lose too much money being diversified across a number of industries. THIS IS EXTREMELY DANGEROUS BEHAVIOR, and it creates a great opportunity for active managers to capitalize on the dislocation that is created by index investors who invest without regard to management competence, balance sheet health, growth or future prospects. SPY is an index fund that tracks the market-capitalization weighted performance of the S&P 500 - market-cap weighted indexes are particularly dangerous.
In his wildly successful book, "Margin of Safety," Seth Klarman articulates in great detail the dangers associated with the index-investing fad:
Indexing is a dangerously flawed strategy for several reasons. First, it becomes self-defeating when more and more investors adopt it. Although indexing is predicated on efficient markets, the higher the percentage of all investors who index, the more inefficient the markets become as fewer and fewer investors would be performing research and fundamental analysis. Indeed, at the extreme, if everyone practiced indexing, stock prices would never change relative to each other because no one would be left to move them.
Another problem arises when one or more index stocks must be replaced; this occurs when a member of an index goes bankrupt or is acquired in a takeover. Because indexers want to be fully invested in the securities that comprise the index at all times in order to match the performance of the index, the security that is added to the index as a replacement must immediately be purchased by hundreds or perhaps thousands of portfolio managers. There are implicit assumptions in indexing that securities markets are liquid, and that the actions of indexers do not influence the prices of the securities in which they transact. Yet even very large capitalization stocks have limited liquidity at a given time. Owing to limited liquidity, on the day that a new stock is added to an index, it often jumps appreciably in price as indexers rush to buy. Nothing fundamental has changed; nothing makes that stock worth more today than yesterday. In effect, people are willing to pay more for that stock just because it has become part of an index.
By way of example, when Blockbuster Entertainment Corporation was added to the Standard and Poor's 500 Index in early 1991, its total market capitalization increased in one day by over $155 million, or 9.1 percent, because so many fund managers were "obliged" to buy it. Indeed, Barron's has calculated that stocks added to the Standard & Poor's 500 Index outperformed the market by almost 4 percent in the first week after their inclusion.
A related problem exists when substantial funds are commit¬ted to or withdrawn from index funds specializing in small-cap¬italization stocks. (There are now a number of such funds.) Such stocks usually have only limited liquidity, and even a small amount of buying or selling activity can greatly influence the market price. When small-capitalization-stock indexers receive more funds, their buying will push prices higher; when they experience redemptions, their selling will force prices lower. By unavoidably buying high and selling low, small-stock indexers are almost certain to under-perform their indexes.
Other perverse effects of indexing are now emerging with increasing frequency. When securities are owned only because they are part of an index and the only stated goal of the owners is to match the movements of that index, the portfolio "manager" responsible for those securities has virtually no interest in influencing the performance of the index. He or she is indifferent to whether the index rises or falls in value, other than to the extent that fees are based on total managed assets valued at market prices.
This means that in a proxy contest, it makes no real difference to the manager of an index fund whether the dissidents or the incumbent management wins the fight, even though the outcome may make a significant financial difference to the clients of the indexer. (By choosing indexing, investors have implicitly expressed the belief that their vote in a proxy contest could make no predictable financial difference anyway.) Ironically, even if indexers wanted to vote in a direction that maximized value, they would have absolutely no idea which way that would be because index fund managers typically have no fundamental investment knowledge about the stocks they own.
It is noteworthy that the boom in indexing has occurred during a bull market. Between 1980 and 1990 the estimated amount of money managed in indexed accounts increased from $10 billion to about $170 billion, with 90 percent of that amount indexed to Standard & Poor's portfolios. An additional $100 billion or more is believed to be "closet indexed," that is, to track, if not exactly match, the S&P 500 Index. According to Barron's, "No little impetus has been supplied to this melancholy trend by the harsh fact that the S&P has laid waste to the performance of conventional managers during the Eighties, particularly in the past five years. For example, the S&P has beaten the average equity mutual fund in the Lipper Analytical Service, Inc., survey in 24 out of the past 31 quarters."10 The S&P 500 Index has also significantly bettered the broadly based Wilshire 5000 Index since the second half of 1983, outperforming it in twenty-three out of twenty-nine quarters; during that period the compound annual total return for the S&P 500 Index was 12.7 percent compared with 10.7 percent for the Wilshire 5000 Index.
I believe that indexing will turn out to be just another Wall Street fad. When it passes, the prices of securities included in popular indexes will almost certainly decline relative to those that have been excluded. More significantly, as Barron's has pointed out, "A self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing." " When the market trend reverses, matching the market will not seem so attractive, the selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits."
Considering the minefield of risks that accrue to the index-investor and will be exposed during the next major pullback, from a logical standpoint, even if these index-trackers change minimal fees - they do so at a very high risk of loss. For instance, let's assume the concern around a major devaluation of the Chinese yuan is warranted, and the yuan collapses next week. Active managers would have already researched this (at least the reasonable ones), be cognizant of its potential to occur, and as a result they would avoid purchasing stakes in companies based in the U.S. with material sales concentrations in the Asia Pacific region (which, after a major yen devaluation, will be on a collision course, or the proverbial 'race to the bottom' due to spillover effects of China's debt problems and currency woes. Those invested with active managers will likely be avoiding stocks heavily exposed to the value of the Chinese yuan, protecting investors from the disastrous consequences that would ensue. Indexed investors would be invested across the board, with several companies that have significant exposure to a fall-off in exports to China as its currency value falls and its companies struggle further to overcome their irresponsible debts.
Think of the passive asset management (PAM) as the boring high school cafeteria food, menus don’t change much unless the suppliers alter. The active asset management (AAM), on the other hand, acts like a fancy restaurant, frequently modifying its menu based on the season or whatever the chefs’ desires may be. Based on that analogy, you may immediately learn which one costs less to run.
PAM constructs its portfolio based on a selected index, whether it is a domestic large-cap or international small cap. Once it’s done, it’s not going to change unless certain companies from the selected index deleted or replaced it. As you can see, this methodology needs the least care and trading, which translates to tremendous cost savings for investors.
In comparison, AAM is destined to be different. It does not follow an existing index; its investment construction is based on the individual manager’s preference and proficiency. Consequently, there are a slew of active managed funds to take advantage of the market conditions, currency exchange, etc. The frequent strategy change, the more executed trades, the more costs are to investors. Thus, the fees for active management are higher than plain-vanilla index funds.
Depending on your needs, instead of choosing one or the other management styles, you can do both by having some solid low-cost broad index funds as your core holding and simultaneously adding a few active funds to boost your return and achieve some diversification. Best!
Active management is the goal of trying to outperform a benchmark. Many mutual funds utilize active management. For example, a mutual fund that invests in large U.S. companies would most likely use the S&P 500 as it's benchmark. The objective of that mutual fund would be to try and outperform the return of the S&P 500. The mutual fund will do this by employing a mutual fund manager and a team of analysts. The mutual fund manager will pick and choose the stocks to include in the mutual fund that he believes will outperform the S&P 500. Active management can also simply be done by picking yourself or hiring an investment manager to pick individual stocks that you/they believe will outperform the S&P 500 or any other stated benchmark. Active management believes that the stock market is inefficient and there are opportunities to make gains based off that inefficiency. Normally, you pay a premium to invest in an actively-managed mutual fund or investment manager since you are paying them for their expertise and their work to pick and choose stocks.
Passive management believes that the stock market is efficient and that consistently outperforming benchmarks in the long-term isn't achievable. Passive management is usually done through ETFs or Index Mutual Funds. With passive management, the goal is to simply match the return of the stated benchmark. Using the previous example, if you wanted to invest in large U.S. companies and wanted to utilize a passive approach, you could buy an ETF or Index Mutual Fund that tracked the S&P 500. In most cases, it is much more inexpensive to employ passive management because you aren't paying a manager for their expertise.
There is a heavy debate in the investment management world right now on which style is best. I believe that depending on the market, passive/active management makes sense. Passive management in large U.S. companies makes sense to me because there is so much information and it's so easily attainable that it makes it hard to find anomalies and price discrepancies that allow for non-normal gains. However, in the Emerging Markets sector where the information isn't as abundant and easily attainable, there is much more room to find "diamonds in the rough" and make larger gains than the stated benchmark. When using active management, make sure you do your due diligence on the investment manager and their track record.
Passive management makes no attempt to forecast securities prices or to time markets based on estimates of future performance. Its goal is to capture as much of the market return as possible through maximization of the concept of diversification. It uses considered asset allocation to divide up the overall portfolio and then essentially retains that allocation throughout all market conditions, although periodically rebalancing it to keep on track.
Passive management can still be achieved through an active and thoughtful selection of particular securities to represent asset classes within the portfolio. In other words, while the ongoing investment management is passive, the selection of the correct representative securities, preferably exchange traded funds (ETFs) can be tactical and selective.
Active management is simply an attempt to apply human intelligence to find “good deals” in financial markets. Active managers try to select what they perceive to be attractive securities (usually individual stocks and bonds) and then make judgment calls to move into or cash out of these securities, placing bets on their future direction. They use a variety of methods, including fundamental, technical and macroeconomic analysis. Their goal is to try and forecast profitable future investment trends and take action to try and profit from them.
Running an actively managed fund is expensive. Running a passive fund is cheap. Therefore, the fees associated with active management are many times more expensive for investors than those associated with passive management.
Active management generates transaction costs and capital gains taxes which are passed on to the investor, exacerbating the problem of active management fees even further.
Active management does not work over the longer term. Mountains of data show that the performance of somewhere between 93-99% (depending which survey you believe) of actively managed funds over a 10 year period fail to even match the index they track. And their is no way in advance to know which fund will be one of the very few outperformers.
So, passive management is cheaper, more tax efficient, and has a nine out of ten chance of achieving better returns over time than active management.
The choice is not difficult.
I'm probably one of the few investment managers who fundamentally believe there's no such thing as truly passive investing. The only way to accomplish truly passive investing yourself, would be to buy a set of stocks and hold them indefinitely. In an article I published last year, entitled "Passive Investing Is Anything But", I detail how holdings within "passive" index funds are reconstituted routinely, during the course of any given year, and over longer periods of time, even result in big changes to their top ten holdings.