Financial professionals and investors alike have debated the merits of active and passive management for a long time. Each investment management style has pluses and minuses that can vary depending on the market climate. The main difference is the investment manager's level of involvement in decision making in managing portfolios. These portfolios can include diverse securities such as stocks, bonds and other asset classes.
Active management involves a hands-on approach where investment managers actively make investment decisions, with the goal to outperform the market or a specific benchmark. Active managers use various strategies to generate higher returns. These include extensive research, analysis, and using their judgment to select investments that they believe will beat the market.
Passive management, also known as index investing, involves constructing portfolios to replicate the performance and risk characteristics of a specific market index rather, than actively trying to do better than the market. Compared to their active counterparts, passive managers tend to make fewer investment decisions. Their aim is to buy and hold the investments in their chosen index with minimal costs.
Active management: Five ways it can add value
1. Finding alpha
The main goal of active management is to outperform the market or occasionally to offer access to investing sectors not as readily available via passive investing. Active managers typically conduct in-depth research (sometimes proprietary) on individual companies or sectors, analyzing financial statements, market trends, economic indicators, and lots more. They then use this information to make changes to portfolios such as investing more or less in a stock, bond, or sector.
The goal of active managers is to beat the market and achieve alpha via the specific investments in the portfolio. Alpha is the excess return above the benchmark (e.g., the S&P/TSX Composite Index) return. Simply said, active managers try to achieve better returns, through the specific investments they select, than their mandated benchmarks.
They can also make active asset allocation decisions using a mix of equities, bonds, and other asset classes.
Some active managers have outperformed benchmarks over specific time periods, especially in specialized sectors (like technology for example) or regions, but also less-efficient markets, such as small cap stocks, emerging markets, or fixed-income securities.
2. Mitigating risk
With active management, much of the success or failure to generate higher returns depends not only on the manager’s ability to identify investment opportunities, but also on their ability to mitigate risk. Proactively identifying, assessing, and mitigating potential risks in a portfolio are essential.
Active managers develop and use various risk-assessment tools and metrics to gauge overall risks such as equity market risk, interest rate risk, credit risk, and liquidity risk. By doing this, they can reduce exposure to high-risk assets and seek safer investments to protect investors’ capital.
What is market risk?
This is defined as risks that can’t be avoided. A well-diversified portfolio may help reduce the risks with individual holdings, but even this portfolio can’t withstand risks that affect entire markets. For instance, rising interest rates could widely affect markets and even a well-diversified portfolio. Other market risks include changes to currency exchange rates and geopolitical events.
This is a vital feature of active management, because it allows active managers to adjust their portfolios in real-time as market conditions change. For managed solutions, active management can greatly help with tactical asset allocation. This involves dynamically adjusting portfolio allocations to capture short-term opportunities and protect investors’ capital against risks based on what’s happening in the markets.
4. Deep expertise
It takes a whole team to constantly monitor various indicators, sector performance, and overall market trends to make proper adjustments to the asset mix. Active management relies on the insights of professional portfolio managers and research teams.
Active managers use deep research to identify opportunities and to capitalize on them, while passive management tries to replicate the performance of an index by buying a basket of securities. The holdings in passive portfolios usually don’t change as much compared to actively managed portfolios.
5. Uncovering hidden opportunities
The goal of passive management is to mirror a benchmark as closely as possible, while keeping costs low. Its low cost drives many investors to make it a substantial part of their portfolios.
However, active managers can have the edge. For example, when markets are volatile and behaving irrationally, performance across stocks, bonds, and sectors will likely vary more compared to when the investment landscape is calmer.
Simply put, active managers have more opportunity to find opportunities that are likely to outperform the market. Compare that to passive managers who are mandated to strictly follow a benchmark and don’t have the flexibility to adapt to changing market conditions. On the other hand, skilled active managers can adjust.
Active management in action at Sun Life Global Investments
The Sun Life Global Investments Multi-Asset Solutions team (MAS Team) relies on a strategic blend of active and passive strategies in their open architecture. Within managed solutions, a key active management tool that MAS team uses is tactical asset allocation. When market reactions cause disruptions that may change the risk/reward profile of certain asset classes from longer-term expectations, the MAS Team can temporarily deviate from the strategic allocation to reduce risk or take advantage of opportunities. Before doing so, they consider 30 independent decision points across levers such as asset mix, asset class, and investment style.
Want to know more on how tactical asset allocation works in an active management strategy? Read this article on how the MAS Team can adjust the tactical mix in the Granite portfolios.
Still not convinced about active management? Ultimately, the debate between active and passive management boils down to individual investor preferences, risk tolerance, and investment goals. Many investors mix them, combining the benefits of active management’s potential for outperformance with the diversification and lower costs of passive investing.
To find out more about what’s right for you, talk to your advisor about the benefits and pitfalls of both approaches. An advisor will help you define your investment goals, risk tolerance, and preferences.
Information contained in this article is provided for information purposes only and is not intended to provide specific financial, tax, insurance, investment, legal or accounting advice and should not be relied upon in that regard and does not constitute a specific offer to buy and/or sell securities. Views expressed regarding a particular company, security, industry, or market sector should not be considered an indication of trading intent of any mutual funds managed by SLGI Asset Management Inc. These views are subject to change and are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. Please note, any future or forward-looking statements contained in this document are speculative in nature and cannot be relied upon. There is no guarantee that these events will occur or in the manner speculated. Information contained in this article has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made with respect to its timeliness or accuracy.