Passive vs. Active – The Beauty of BothSheaff Briefs Editor
One question any investor must consider is whether to take an active or passive approach to investing.
Per Investopedia, “The predominant investment strategy today is active investing,” which attempts to beat a particular benchmark and “outperform the market.” Continuing, the article points out, “anomalies and irregularities in the capital markets can be exploited by those with skill and insight.”
By contrast, passive investing, the authors explain, is an approach based on investing in exactly the same securities, in the same proportions, as an index. Portfolio managers don’t make decisions about which securities to buy and sell, but try to replicate the performance of an index or a broad sector of the market as closely as possible.
Sheaff Brock Director Jim Murphy, CFP®, CAIA, believes there’s a place for both approaches to the market, dubbing the combination strategy “Core and Satellite.”
- “The core” consists of passive investing in asset classes (through indexes) with the goal of maintaining overall market type returns.
- “The satellites” are actively managed assets in which the goal is to add Alpha (the managers’ ability to achieve excess returns) to the portfolio.
Some of the policies and initiatives being instituted by the new administration—notably deregulation and an emphasis on infrastructure—might suggest shifting portfolio proportion in favor of more active investments. In an interview with our SheaffBriefs editor, Murphy suggested that we might well begin to see less of a correlation between sectors and individual stocks— “instead of a stock market, we might be looking at a market of stocks.”
One performance measurement not widely published but used by institutional investors, Murphy added, is the Capture Ratio, which reflects how much incremental value is added to a portfolio on both the upside and the downside through active management.
Upside capture indicates how much active management added to performance results on the upside (net of fees). 100% capture would merely duplicate index results; the idea is to realize a capture rate of more than 100% to show an additional increase in portfolio value due to active management.
With downside capture, the desired rate is below 100%. This shows how well active managers, net of fees, were able to avoid the higher portfolio losses suffered by passive investing during periods when the benchmark index was in the red.
Passive vs. active investing—there’s beauty in both, Sheaff Brock has learned over the years. As investors consider whether to take an active or passive approach to investing, Murphy suggests, the answer might be a Core and Satellite approach, tapping into “the beauty of both.”