Active or Passive? How to Blend Aspects of Both
August 26 2014 - 7:00PM
ETFDB
Investment fund strategies can broadly be divided into either
active management or passive management. The former refers to funds
actively managed by financial professionals who typically try to
outperform a given benchmark, while the latter describes funds that
seek to track a particular index.
For most investors, deciding on whether to use active or passive
funds is largely a matter of faith or disposition. Occasionally,
the debate becomes surprisingly impassioned, which often leaves
people slightly amused, as investment professionals get in a froth
about arcane topics such as tracking error or information
ratios.
However, while somewhat esoteric, the topic is not irrelevant.
Over the long term, implementation, i.e. how you choose to use
active and or passive funds in your portfolio, is a critical driver
of investment returns.
While the debate between active and passive will never truly be
settled, investors can sidestep the acrimony and embrace a simple
approach that blends both to help build a better portfolio. That of
course leaves the question of how and when to combine active and
passive. Here are five criteria to consider as you’re figuring out
the right blend for you.
Active Funds
Look for active funds with broad mandates. Like physics, finance
has its key formulas. One of the most useful, if not the most
famous, is the Fundamental Law of Active Management. It basically
states that an active manager’s ability to add value is a function
of his or her skill and the “breadth” of the mandate. Breadth
refers to the number of different investments a manager can make.
What this rule implies is that broad mandates – defined either by
lots of countries or lots of asset classes – provide more fertile
ground for active managers.
Consider active funds for asset classes that are difficult to
represent with an index. Some asset classes, U.S. large caps for
example, lend themselves to indexing, as they are easy to replicate
within an Exchange Traded Fund (ETF) or index mutual fund. Others
asset classes, such as bank loans, are more difficult to represent
with an index. For these, you may want to consider active
management, which can potentially take advantage of the many
illiquid issues that are often part of these asset classes.
Think of active funds as long-term, core holdings. Most
investors realize that timing markets, i.e. trying to trade in and
out of stocks or bonds in an attempt to minimize losses, is
difficult. So is trying to time active performance. In other words,
if you have an active manager, give them a fair chance. For active
funds, you want to make sure you hold them long enough, at least
through an economic cycle, to give the manager enough time to
potentially generate positive active returns.
Passive Funds
Consider passive funds when you’re trying to achieve precise
exposure to certain asset classes (e.g. style-box investing) in a
cost effective and tax efficient manner. Some narrow index
benchmarks – think large-cap value stocks or medium-cap growth
stocks — are generally easy to replicate with a passive fund. ETPs
and other index products typically offer a low cost, transparent
and tax efficient mechanism to gain exposure to such core asset
classes, such as major equity or fixed income markets.
Think of passive funds for tactical exposure. For investors
looking to tactically (i.e. frequently) adjust their exposures to
certain markets and asset classes, exchange traded products (ETPs)
are an excellent vehicle. They are liquid and cost effective, thus
providing an ideal vehicle to adjust portfolio exposures based on
short-term market conditions.
Many will notice one dimension that is missing from the above
list: macro conditions.
Investors often ask if there are certain economic or market
conditions that favor one style over the other. BlackRock’s
research suggests that adopting a long-term, strategic framework
governing the blending of active/passive is more productive than
trying to flip from style to style. Each investment strategy offers
its own advantages, suggesting that the most robust portfolio is a
combination of both.
Of course, the right blend of index and active investments for
you will depend on your particular risk tolerance and investing
goals, but the five criteria above are a good starting point.
For more information on the differences between index and active
funds visit iShares.com.
Sources: Bloomberg, BlackRock Research
Russ Koesterich, CFA, is the Chief Investment Strategist for
BlackRock and iShares Chief Global Investment Strategist. He is a
regular contributor to The Blog.
Carefully consider the Funds’ investment objectives, risk
factors, and charges and expenses before investing. This and other
information can be found in the Funds’ prospectuses or, if
available, the summary prospectuses, which may be obtained by
visiting the iShares ETF and BlackRock Mutual Fund prospectus
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principal.
The strategies discussed are strictly for illustrative and
educational purposes and should not be construed as a
recommendation to purchase or sell, or an offer to sell or a
solicitation of an offer to buy any security. There is no guarantee
that any strategies discussed will be effective. The information
provided is not intended to be a complete analysis of every
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