Module for Beginners
Portfolio management strategies: active vs passive
Let’s assume that you’re a football coach looking to build a dream team. What do you do? First, you select the right players to build your team. Then, you draw up a game plan and ensure that they train and perform according to the schedule. And at the end of the game, you sit down with them, analyse their performance and see who can improve in what areas. That sounds about right, doesn’t it?
Drawing parallels, as an investor, your investment portfolio is your sports team. To make sure that your investment portfolio gives you the returns you seek, you need to adopt a strategy that’s more or less similar to the example we discussed above. Here’s where portfolio management strategies can help.
What is a portfolio management strategy?
A portfolio management strategy essentially involves the following elements.
- Picking the right investment options for your individual investor profile
- Monitoring their performance to ensure that they meet your financial objectives
It involves a lot of research into investment options, companies, their opportunities and threats and their future growth prospects. On the face of it, there are two main portfolio management strategies that you should know about - active and passive. Let’s take a brief look at each one of them, shall we?
Active portfolio management strategy: An overview
An active portfolio management strategy involves buying and selling of investments with an aim to outperform a broad market index. Generally, investors who adopt this approach enlist the help of a professional portfolio manager, who uses experience and expertise to strategically choose the options to invest in. In other words, such a portfolio manager is much like a hands-on coach, who is constantly monitoring the team and making changes when needed.
An active portfolio management strategy involves conducting in-depth research into the companies, forecasting of market trends and closely following the changes in the economy and political landscape. The data that is collected from these activities is then put to use to purchase and sell investments.
Since the active portfolio management strategy involves the use of comprehensive data and extensive analysis, it is widely believed that this strategy would generate returns that are higher than the market. Equity mutual funds are prime examples where an active portfolio management strategy is employed.
Characteristics and advantages of active portfolio management strategy
Now that you know what this strategy is, let’s take a look at some of the characteristics and advantages it offers investors like you.
- It provides you with an opportunity to outperform the market.
- It gives you the ability to employ various sub-strategies and techniques.
- Since investments are bought and sold regularly, this strategy has a high portfolio turnover.
Passive portfolio management strategy - an overview
A passive portfolio management strategy is an approach that aims to mimic the performance of a broad market index. It involves constructing a portfolio and constituting it with the same investments as in a broad market index. Here, the role of a professional portfolio manager is very limited. Compared to active portfolio management, this strategy is far more relaxed and laid-back.
Remember reading about efficient market hypothesis in the previous module? The passive portfolio management strategy is based on this theory. It assumes that the market factors in all the available information and that no amount of analysis or research can help you gain an edge. Therefore, this strategy does not involve the use of extensive analysis, research, or comprehensive data.
Since this strategy employs a buy and hold approach, it is the perfect choice for long-term investors looking to replicate the returns generated by the market. Index funds are ideal examples of a passive portfolio management strategy.
Characteristics and advantages of passive portfolio management strategy
Here’s a quick glimpse of some of the distinctive characteristics and advantages offered by a passive portfolio management strategy.
- It provides you with the ability to match the returns of the market.
- The costs associated with passive portfolio management strategy are very low.
- Passive portfolio management gives you a high level of transparency with respect to the portfolio’s constituents.
- Since the stocks are not sold immediately after they’re bought, the portfolio turnover is little to none.
That brings our introduction to these two portfolio management strategies to a close. If you’d like to fine-tune your portfolio management skills, head to the next chapter to find out more about the errors that you need to avoid.
A quick recap
- A portfolio management strategy essentially involves the following elements: picking the right investment options for your individual investor profile and monitoring their performance to ensure that they meet your financial objectives.
- There are two main portfolio management strategies that you should know about: active and passive.
- An active portfolio management strategy involves buying and selling of investments with an aim to outperform a broad market index.
- It also involves conducting in-depth research into the companies, forecasting of market trends and closely following the changes in the economy and political landscape.
- A passive portfolio management strategy is an approach that aims to mimic the performance of a broad market index. It involves constructing a portfolio and constituting it with the same investments as in a broad market index.