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:
- 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
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.
