One of the longest-standing debates in investing is over the relative merits of active portfolio management versus passive management.
With an actively managed portfolio, a manager tries to beat the performance of a given index or market by using his judgment in selecting individual securities and deciding when to buy and sell them.
A passively managed portfolio attempts to match that benchmark performance and, in the process, it tries to minimize any expenses that can reduce an investor’s net return.
Each camp has strong advocates who argue that the advantages of its approach outweigh those for the opposite side.
Proponents of active management believe that by picking the right investments, taking advantage of market trends and attempting to manage risk, a skilled investment manager can generate returns that outperform a benchmark index.
For example, an active manager whose benchmark is the Standard & Poor’s 500 Index might attempt to earn better than market returns by overweighting certain industries or individual securities, allocating more to that holding than the index does. So a manager who loves Exxon may make Exxon 10 percent of the portfolio when it is only 3 percent of the market. A manager might try to control a portfolio’s overall risk by omitting that security when he believes it is a drag on performance. The manager also may temporarily increase the percentage devoted to more conservative investments, such as cash alternatives.
Advocates of unmanaged, passive investing – sometimes referred to as indexing – have long argued that the best way to capture overall market returns is to use low cost, market tracking index investments. This approach is based on the concept of the efficient market, which states that because all investors have access to all the necessary information about a company and its securities, it’s difficult to gain an advantage over any other investor. That market efficiency, proponents say, means that reducing investment costs is the key to improving net returns.
Indexing does create certain cost efficiencies. Because the investment simply reflects an index, no research is required for securities selection. Also, because trading is relatively infrequent, passively managed portfolios typically buy or sell securities only when the index itself changes thus reducing trading costs. Also, infrequent trading typically generates fewer capital gains distributions, which means relative tax efficiency.
An alternative approach
The core/satellite approach represents one way to have the best of both worlds. It is essentially an asset allocation model that seeks to resolve the debate about indexing versus active portfolio management. Instead of following one investment approach or the other, it blends the two.
The bulk, or “core,” of your investment dollars are kept in cost-efficient passive investments designed to capture market returns by tracking a specific benchmark. The balance of the portfolio is then invested in a series of “satellite” investments, in many cases actively managed, which typically have the potential to boost returns and lower overall portfolio risk.
While core holdings generally are chosen for their low-cost ability to closely track a specific benchmark, satellites are generally selected for their potential to add value, either by enhancing returns or by reducing portfolio risk.
Good candidates for satellite investments include less efficient asset classes where the potential for active management to add value is increased. That is especially true for asset classes whose returns are not closely correlated with the core or with other satellite investments. Since it’s common for satellite investments to be more volatile than the core, it’s important to always view them within the context of the overall portfolio. Devoting a portion rather than the majority of your portfolio to actively managed investments can allow you to minimize investment costs that may reduce returns.
While the active vs. passive debate will always be here, understanding it should be beneficial to the investor.
Life is a journey; plan for it.