- An index fund will not match the performance of the index precisely. For example, the fund will have operating expenses whereas the index itself does not. The issue of how accurately the index is to be replicated compared with the costs of doing so also needs to be considered
- The performance of an index may not be optimal
- Restrictions may stop a manager from taking positions (or, put more starkly, using his/her brain)
- Replication may be difficult, particularly if some index constituents are illiquid
- You have to own whatever is in the index
23 Jun 2014
Passive vs. Active Management
This has nothing to do with conjugating verbs in Latin! Rather, it reflects a critical difference in investment philosophy. Passive management reflects the belief that markets are efficient and therefore it is not possible to beat the market. Hence, there is no point in hiring an active manager to produce a tailored portfolio, as he/she is unlikely to outperform in the long term and will charge higher fees.
There are two strands of passive management. Immunisation (typically used by pension funds) is a duration-based strategy to ensure greater certainty of cash flows by matching assets and liabilities more closely. Indexation replicates a benchmark index performance.
There are several arguments that can be advanced against indexation:
Set against these arguments, one can say that the risk with an active strategy is that the fund manager performs poorly (sub-optimal asset selection) and charges you more for doing so!
Active investment strategies are designed to enable the portfolio to outperform the market by taking positions (overweight, underweight or no position) that are different to the constituents of the index. The magnitude of risk relative to the benchmark that the fund manager can take is determined by the tracking error.
A top-down strategy is one which sits within a macro-view that decides how to allocate assets by country, asset class, sector and their individual stocks.
A bottom-up strategy is essentially “stock picking”. One of the most successful stock pickers is Anthony Bolton, whose Fidelity Special Situations Fund was a fairly consistent market outperformer for 25 years.