Active and Passive Management during Financial Planning
Updated: 4 days ago
Author: Sara Diamante
Date of Publication: 05/05/2023
How to realise a financial strategy?
The most popular method of making an excellent financial strategy is the top-down method. This involves first identifying the macro asset classes to be included in the portfolio. In the second step, individual and specific asset classes are identified.
The top-down approach consists of the separation of three distinct steps:
1. Strategic asset allocation (medium/long-term asset allocation)
2. Tactical asset allocation (short-term asset allocation)
3. Stock picking (identification of individual instruments)
Thus, the first thing to establish is the weight that different asset classes should have and maintain within the portfolio in the long run. In fact, this will help us to ensure the risk-return combination that one wants to achieve. Also at the strategic asset allocation stage, another important decision must be made. For each asset class must be identified the benchmark on which to make risk-return forecasts.
Once the benchmark is identified, one must determine what type of management to implement. There are two alternatives:
1. Active management
2. Passive management
Proceeding with active management, the goal is to "beat the market". That is, to obtain an extra return greater than that recorded by the benchmark itself. The portfolio manager, in this type of management, will implement an asset allocation different from that of the benchmark. To be favoured in terms of weight will be the asset classes that the manager expects to outperform the average.Therefore, the objective of active management can be achieved through the decisions made in stock picking and market timing.
Successful stock-picking decisions depend on the manager's ability to identify over/under-listed securities to take advantage of market inefficiencies. In fact, the manager should first estimate a range of price fluctuations. Then, it is good to intervene when the prices fall below the lower limit or when they exceed the upper limit.
On the other hand, success in market timing decisions occurs when the manager can identify the most appropriate time to enter the market. Therefore, the manager must "anticipate the market," that is, sell just before a downturn and buy just before an upturn.
At this point, it is easy to see that active management could bring higher returns. It also gives more flexibility to the manager who is free to formulate an asset allocation more in line with his own analysis. At the same time, management costs are inevitably higher because of more detailed appraisals and forecasts.
In contrast, in passive management, the benchmark identified by the manager represents an indicator to be faithfully replicated. In particular, passive management has a fundamental assumption at its base: the efficiency of markets. Thus, if markets are efficient, it is not possible to beat them.
Obviously, in the stock picking phase, the goal is to identify stocks that can minimise in terms of return the deviation from the benchmark. These deviations are measured at the performance evaluation stage by the “Tracking Error”. Therefore, this is an indicator given by the standard deviation of the difference between the return of a security and the return of the benchmark.
One of the great advantages of passive management, in addition to a reduction in management costs, is less intervention by the manager. The latter will only have to choose which index to replicate and how to replicate it. So, full replication can be implemented, so the same securities and the same weights, or proceed through sampling if the index is too broad.
An example of passively managed instruments : ETFS
These financial instruments originated in the U.S. in 1993 on the Standard & Poor's index. More specifically, they are open-ended, indexed mutual funds. Their innovative aspect is that they are listed on the stock exchange, unlike all other funds.
Moreover, their distinguishing feature is that they faithfully replicate the returns of stock, bond, or commodity indices. What’s more, they are extremely versatile in use because of their continuous trading capability. In fact, ETF units can be traded within the same day.
In addition, one of the biggest advantages is that they have no entry fees or performance fees. They still retain management fees, but the overall costs remain significantly lower. Also, it should be considered that they allow the investment of small, fully liquid amounts since the minimum trading amount is one share.
Physical and synthetic replication
The largest classification of ETFs is one that divides them into:
1. Physical replication ETFs
2. Synthetic replication ETFs.
The former replicates the performance of the same securities contained in the benchmark. The latter, on the other hand, invest in different securities than those contained in the benchmark. Then, it replicates them with Swap contracts. In both cases, there is counterparty risk, but in synthetically replicated ETFs it is higher due to the absence of collateral.
EU regulations impose a counterparty risk limit on synthetic ETFs: each ETF cannot exceed 10 percent of Nav on a per-counterparty basis. All in all, it is good to remember that active and passive management can coexist. Indeed, considering them complementary allows us to achieve greater diversification and flexibility in the medium to long term.