Equity portfolio management styles fall into either a passive or an active category. Active equity portfolio management is an attempt by the investors to outperform, on a risk-adjusted basis, the benchmark portfolio.
A benchmark portfolio is generally a portfolio whose average characteristics match the risk-return objectives of the investors; it could be BSE Sensex, or NSE Nifty, or any other indices, for that matter.
Benefits of active portfolio management
Investors make informed decisions based on their judgments, prevailing market trends, the economy, political and other current events, and company-specific factors such as earnings growth, etc. Investors’ aim is to beat the performance of the index and they can make changes if they believe that the market may take a downturn.
However, there are shortcomings of active portfolio management. The operating expenses are higher as the portfolio needs to be frequently changed. There is always the risk that the investors may make unwise choices of securities, which could reduce the returns.
Passive equity portfolio management
It is a long-term buy-and-hold strategy. Usually, shares are purchased so that the portfolio’s returns track those of a market index over a period time. This kind of portfolio is something similar to that of Index funds. Occasional rebalancing is needed as dividends must be reinvested and because stocks merge or drop out of the target index and other stocks are added. Notably, the purpose of passive portfolio management style of portfolio is not to beat the target index, but to match its performance and, in this process, minimise expenses that can reduce investor’s net return.
There are a few benefits of active portfolio management. Operating expenses are low as the turnover is generally low, especially compared to actively managed portfolios. Low turnover not only holds down the cost of trading, but also leads to greater tax efficiency.
Among the drawbacks, investors have to be satisfied with market returns. They normally cannot make use of the opportunities available in the market, such as buying shares based on the prevailing market trends, political and other current events, etc.
Which approach works best?
Proponents of each camp believe that their approach is the right one, the one that has the potential to generate the greatest amount of return over the long term. Hard facts aside, active and passive management are in many ways similar to political parties. The two camps see the investment world in very different ways, both making logical and passionate arguments for their viewpoint.
One could take the position of a hybrid active/passive equity portfolio management styles, but such styles really are variations of active management philosophies. Similar to traditional active management, hybrid-style managers invest to find undervalued sectors or securities. And from time to time, one approach will be more popular than the other.
As an individual investor one should try to ignore the trend of the moment. When all is said and done, keep in mind that both active and passive managers are selecting investments from the same pool of equities.
* The writer is an associate professor in finance and accounting at IIM Shillong