May 18, 2010
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The active-passive debate typically centers on the nature of the investment product – whether it is an actively managed fund or a passive index fund. This, however, is only one aspect of that debate, and to consider it alone represents too simplistic a view.
A broader issue, namely how a portfolio of actively or passively managed funds is managed over time, has a more profound impact on whether one is truly an active or passive investor.
For example, a high-turnover portfolio of index funds is more appropriately characterized as an actively managed portfolio of passive index funds. Very simply, it is an “active/passive” portfolio. By contrast, an investor or advisor who purchases index funds using a buy-and-hold approach has a “passive/passive” portfolio.
One can be an active manager of passive funds, or a passive manager of actively managed funds.
A die-hard index fund advocate may be “passive” at the instrument level and “active” at the portfolio management level. Conversely, an investor who invests in actively managed funds may be passive in their ongoing management. Viewed this way, it’s difficult to determine which investor is passive and which is active.
In fact, there are four primary combinations of active and passive, as shown in Figure 1.
Figure 1. The Active/Passive Grid
|
Passive Index |
Actively Managed |
Passive Portfolio Management |
Passive / Passive |
Passive / Active |
Active Portfolio Management |
Active / Passive |
Active / Active |
Note that the word “financial advisor” could be substituted in place of the word “investor” in each of the four active/passive scenarios – the framework applies just as well.
The distinction between the use of “active” portfolio ingredients and the “active” management of the portfolio ingredients is key. The value of “active” management at either level can only be determined by establishing a properly “passive” baseline portfolio for comparison.
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