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Passive and active portfolio management are the two main strategies that investors can utilize to generate a return on their investments.
We highlight the fundamentals of each of these strategies below.
Passive investment management
Passive investment entails investing in passive investment funds. The manager of the fund accepts instructions from investors to buy or sell a given percentage, and because the input required from the fund manager is relatively small, this investment style is known as ‘passive investing’. Due to the lack of detailed analysis and significant investment decisions, the management and operating fees are much lower than those of actively managed funds.
Passive investment funds are also called ‘index-tracking funds’, as they track the performance of a specific index, such as an equity index (for example, the JSE Top 40), the property or industrials index, commodities (for example, gold or oil), or the bond index. These indices are constructed in such a way as to approximate the economic performance of the overall market or a market segment. The overarching principle of index tracking is that it’s a strategy designed to match a market, not outperform it. For passive investing, the associated risk is market-related only.
The fund that is invested into when following a passive investment strategy is either an exchange-traded fund (ETF) or a passive unit trust fund — the difference between passive unit trusts and ETFs is that ETFs are listed on the JSE and can be traded intra-day, while unit trusts are not.
Most ETFs in South Africa are structured as collective investment schemes (CISs), which is another name for unit trust companies. ETFs combine all the benefits of a unit trust, such as investor protection (since the assets are held in custody on behalf of investors), full disclosure, and tax benefits, with the convenience and efficiency of trading a listed security.
Due to the nature of the strategy, passive investments are fully invested in the market index, with little or no exposure to alternative assets, such as cash. This means that investment values will be negatively affected in a prolonged market downturn, as there is no diversification of assets that may soften the blow.
Active investment management
In an actively managed fund, the aim of the fund manager is to outperform the market. Fund managers do this by attempting to take advantage of pricing inefficiencies. Active fund managers conduct detailed research on companies and compare their valuations of the companies’ share prices to the actual share prices. This includes an evaluation of the company’s historic, current and expected future earnings, given the state of the economy as a whole and that of the sector in which the company trades. Fund managers strive to create a profit for the fund by buying shares when they believe these to be undervalued and selling shares when they believe them to be overvalued.
Fund managers of actively managed funds follow methodical research processes to identify shares they believe will provide the best performance, and they actively manage the funds by buying and selling shares. This translates into more costs and higher management fees than those associated with passively managed funds.
The active involvement of the fund manager results in more volatile investment results than those of an index-tracking fund, as the risks are market- as well as manager-related. To minimise market risks, active managers vary the type of shares and amount of cash held, based on their judgment of market conditions and share prices.
As is the case with most important financial decisions, it is advisable to consult your financial advisor to assist you in choosing the investment strategy that is best suited to your investment requirements and objectives.
The information contained on this website (or in this article) is of a general nature and intended for information purposes only. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial, legal or other issue. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner/advisor to take into account your particular investment objectives, financial situation and individual needs.