Investment Strategies

Comparing passive and active approaches to portfolio management

By Stephen Flegg
BCom, MEc, MAppFin, DipFinServ, GradDipTeaching Portfolio Manager Sydney, Australia

One of the most fundamental aspects of investing is the decision between active and passive approaches to portfolio management. Each has their own objective and is suited to certain circumstances, in particular the prevailing monetary conditions.

Passive asset management

Passive asset management aligns the growth asset profile of the investment with a particular risk profile, from conservative through to high-growth. The manager will also attempt to offer a diverse and stable mix of the major asset classes and, within those asset classes, try to track the underlying market. Other objectives are to maintain a highly-liquid portfolio and maintain it at a low cost. The buy-and-hold nature of a passive approach lends itself to low-cost investing, as transaction costs and management fees are typically lower due to a lower velocity of trading.

Well-constructed, a passively-managed portfolio will effectively replicate the universe of investment products within the bounds of the fund, often the liquid listed product base of equities and bonds.
Investors and managers alike must be comfortable that when the market corrects, the fund will move with it; the intention being that over the long term, these corrections will be ironed out by market gains. In fact, managers of a passive fund will usually be more concerned when it fails to correct with the market, indicating a tracking error with the composition of the fund.

Active asset management

Rather than tracking market performance, active funds seek a target rate of return. They offer a point of difference with the broader universe of investable instruments, to which most Australians are already heavily exposed through their superannuation.

Active managers find their edge through investing in selected assets from similar classes to typical passive investments, but also employ a greater bandwidth at an asset class level to exploit different types of opportunities.

The performance of an active fund can be assessed via a hit rate, which measures the percentage of time where it exceeds its target return.

Different market conditions favour differing approaches

Over the past decades, as the developed economies have experienced a period of relatively stable monetary policy, passive management has become an increasingly popular strategy. In times of low volatility such as these, it is generally more difficult for an active manager to find an edge, or to generate alpha (i.e. excess returns) net of transaction costs over and above the market return.

However, with the scope for further monetary easing diminished, and uncertainty around global trade, and government policy more broadly, the global economy could be entering a period of increased volatility, which better suits an active approach to management. In this environment, the uneven effects of global events, overlaid on individual asset fundamentals, create opportunities for those managers who are able to generate genuine insights and add real value to their portfolios.

Within AMP, there are two groups of funds that typify these two approaches.

The MyNorth index diversified funds (MIDF) are managed according to a passive strategy: structured to meet a generic risk profile with the aim of closely tracking market indices. Their asset allocation is stable and diversified across the major asset classes, and they thrive in low-volatility markets at times where the major asset classes of equities and bonds are performing strongly.

In contrast, the Dynamic Markets Fund (DMF) is managed against a real return target of CPI1 + 4.5%. The group of assets to which it is exposed are dynamically managed through the course of the cycle, and include the major asset classes as well as a selection of minor asset classes such as commodities, currencies and other hedges.

While these portfolios are each suited to particular market conditions, it’s important to bear in mind that other factors should come into play when determining an approach, including the individual goals and risk appetite of the investor and investment horizon.

The choice between passive and active investment management is seen by many as a zero-sum game, when in truth many investors will allocate capital across both strategies. The question for the investor should therefore not be “which strategy”, but rather the proportion allocated to each and at what time.

1 The Reserve Bank of Australia inflation rate (Consumer Price Index) - trimmed mean 

Subscribe below to Market Watch to receive my latest articles

Stephen Flegg, Portfolio Manager
  • Economics & Markets
  • Goals-Based Investing
  • Investment Strategies
  • Market Watch
Share this article

Subscribe to our Insights

Here's what we found for you

Here's what we found for you

Here's what we found for you

Here's what we found for you

Our Privacy Policy explains how we handle personal information and use cookies and website tracking. We will follow the cookie and tracking settings you have selected in your browser.

Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

 

This article is not intended for distribution or use in any jurisdiction where it would be contrary to applicable laws, regulations or directives and does not constitute a recommendation, offer, solicitation or invitation to invest.

Cookies & Tracking on our website.  We use basic cookies to help remember selections you make on the website and to make the site work. We also use non-essential cookies, website tracking as well as analytics - so we can amongst other things, show which of our products and services may be relevant for you, and tailor marketing (if you have agreed to this). More details about our use of cookies and website analytics can be found here
You can turn off cookie collection and/or website tracking by updating your cookies & tracking preferences in your browser settings.