INVESTMENT AND PORTFOLIO MANAGEMENT CHAPTER 7

MANAGING PORTFOLIOS –
ACTIVE AND PASSIVE STRATEGIES

TOPICS:
1. PASSIVE PORTFOLIO MANAGEMENT
i. Advantages
ii. Disadvantages
2. ACTIVE PORTFOLIO MANAGEMENT
i. Advantages
ii. Disadvantages
3. PASSIVE PORTFOLIO STRATEGIES
4. ACTIVE PORTFOLIO STRATEGIES
5. DIFFERENCES OF PASSIVE AND ACTIVE
6. FACTORS TO CONSIDER IN PASSIVE & ACTIVE
7. DECISION BETWEEN PASSIVE & ACTIVE INVESTING

Investors often debate the merits of active and passive fund management when building their
investment portfolios. Passive portfolio management involves replicating a market index, aiming for
steady growth with minimal trading and lower costs, making it an appealing passive portfolio strategy. In
contrast, an active portfolio strategy seeks to outperform the market through frequent buying and
selling based on market trends and stock selection. While passive portfolio management offers a
straightforward and cost-effective approach, active and passive fund management each have unique
benefits. Each method has its own advantages and disadvantages; what it comes down to is about the
different types of investors and their comfort with risk. By understanding the nuances between a
passive portfolio strategy and an active portfolio strategy, investors can tailor their approach to meet
their financial objectives and risk tolerance.

Let’s dig a little deeper into both active and passive fund management, we will look at their strategies,
advantages, and other important things to factor in when choosing between active or passive investing.

PASSIVE PORTFOLIO MANAGEMENT

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Passive portfolio management is all about making a portfolio that looks similar to a certain market index
or benchmark. Main goal is to copy how the market performs and not necessarily to do better than it.
Managers of passive portfolios don’t track how individual investments are doing, they don’t continuously
monitor and change the constituents of a portfolio. The idea is simple - keep it the same as what's present
in the index or the benchmark we are following.

● Advantages of Passive portfolio management:

 Low Costs: Passive portfolio management typically involves lower fees and expenses compared
to active management since trades are limited in nature and analysis is only to the extent of
what is comprised in the benchmark index - so transaction costs are minimal.

 Consistency: Passive portfolio management provide consistent exposure to the broader market,
reducing the impact of market fluctuations on the portfolio's performance.

 Tax Efficient: Less trading also means less short term capital gains are incurred which means,
passive portfolios are more tax-efficient than active portfolios.

 Diversification: Since investing in passive portfolio management strategies involves adding

constituents that are the same as the benchmark or the market index, it inherently provides
higher diversification benefits

 Accessibility: Index funds and exchange-traded funds (ETFs) both use passive portfolio
management strategies that are widely available, easily accessible and have lower minimum
investment requirements

● Disadvantages of Passive portfolio management

 Not built for Outperformance: Passive funds aim to match the benchmark index’s return but
will in most cases never outperform it since the passive portfolio strategy just copies the index

 Lack of Customization: Each passive fund is built targeting a specific index. As such, investor’s
specific needs and preferences cannot be catered to with an index as there is no room for
customization.

ACTIVE PORTFOLIO MANAGEMENT

Active portfolio strategy is the opposite of passive portfolio management - the objective is to beat the
market or a specific market index/ benchmark like the Nifty50, BSE500 or Nifty Smallcap 100 - the exact
benchmark will depend on the active management strategy that is used. Active portfolio strategy
managers are hands-on, they decide what investments need to be added and removed from a portfolio.
They use research, data, conduct fundamental/ technical analysis and what they know about the market
to find good opportunities and change what's included in the portfolio.

● Advantages of Active Portfolio Management

 Potential for Higher Returns: Active portfolio strategy managers exploit market inefficiencies,
select high-performing securities, and time their trades to beat the market

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 Tailored Strategies: Based on the investor’s specific investment goals, risk tolerance, and overall
market trends, Active portfolio strategy managers can create customized portfolios that suit the
investor

 Flexibility: Active portfolio strategy managers can quickly adapt to changing market conditions,
reallocate assets away from riskier to safer assets or vice versa, and accordingly select securities
and assets

 Risk Management: Quicker response time from active portfolio strategy managers, means they
can respond to market conditions faster than passive managers and can even, reduce risk by re-
adjusting allocations to more conservative investments. All of this may help minimize losses
during market downturns.

 Tax Considerations: Active portfolio strategy managers can time selling assets and securities
that are in their portfolio to reduce capital gains or employ loss-harvesting strategies for getting
tax benefits.

● Disadvantages of Active Portfolio Management

 Higher Costs: Actively managed portfolios often have higher trading costs due to frequent
transactions.

 Limited Flexibility in Mutual Funds: Actively managed mutual funds may have constraints that
limit the manager's ability to pivot or adapt to market changes.

PASSIVE PORTFOLIO MANAGEMENT STRATEGY

Passive portfolio strategy selecting index-based funds or exchange-traded funds (ETFs) that replicate
the performance of a particular index. These funds mirror the asset allocation of the chosen index and
require minimal ongoing management. The goal is to achieve market-like returns, making it suitable for
investors seeking long-term growth with lower costs. Let’s go through a few of them –

1. Index Investing
Index investing involves mirroring a particular market index, such as the Nifty50, BSE300 etc.
Investors get exposure to the market's performance at a low cost. However, there is limited or
no chance for outperformance and investors do not have any way to customize these indices.

2. Strategic Asset Allocation

Strategic Asset Allocation is achieved by diversifying across different asset classes such as bonds,
stocks, and cash to mitigate risk and achieve more stable returns. Tailoring to individual risk
tolerance and investment goals allows for better risk management. This is a longer term strategy
that again focuses on limited trading - however it does require ongoing monitoring and
adjustments, and may lack potential for higher returns.

3. Buy-And-Hold Investing
Buy-and-hold is a long-term investment strategy that focuses on buying and holding quality
assets with the objective of limited/ minimal trading. The benefit is that it reduces transaction
costs and taxes. By holding quality assets for longer time periods, we are relying on letting

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compounding returns provide long term benefits. However, the strategy can be impacted if the
selected assets underperform.

ACTIVE PORTFOLIO MANAGEMENT STRATEGY

Active portfolio management involves undertaking detailed research and analysis, of securities and
ongoing monitoring of market conditions - all of this provides significant in terms of what they actively
focus on buying and selling securities. Active portfolio management focuses on generating alpha returns
by not just outperforming the benchmark index, but also capitalizing on mispriced securities or market
inefficiencies to generate excess return or alpha.. Let’s go through a few of them –

1. Fundamental Analysis
Fundamental analysis requires evaluating a company's financial health and growth potential by
analyzing their financial statements, competitive advantages, corporate governance issues etc.
The aim is to come up with an intrinsic value of the asset which can then be compared against
the market value to determine if an asset or a security is under valued, par or over valued.
Under-valued stocks can be buying investment opportunities and over-valued stocks can be
good selling investment opportunities. However, this approach is not just time-consuming, but it
really depends on the inputs such as the quality of the information available that goes into
deriving the intrinsic value.

2. Technical Analysis
Technical analysis focuses on analyzing historical price and volume data to identify patterns and
trends. It is useful for short-term investment strategies and can signal buying or selling
opportunities. The focus is on identifying patterns in the charts and the data and not on any
information that is concerned with the fundamentals of the business or broader macro-
economic trends

● Key Difference Between Active and Passive Portfolio Management

Understanding the difference between active and passive portfolio management is crucial for investors.
Let's look at the main difference between active and passive portfolio management to understand how
they work –

ACTIVE MANAGEMENT PASSIVE MANAGEMENT

Attempts to beat benchmark performance Attempts to match benchmark performance
Contends pricing inefficiencies in the market Contends that it is difficult or impossible to "beat
create investing opportunities the market"
Focuses on choice of specific securities and Focuses on overall sector or asset class
timing of trades
Securities selected by portfolio manager Securities selected based on an index
Trading and the degree of liquidity for individual Infrequent trading tends to minimize portfolio
securities may increase portfolio costs expenses

The primary difference between active and passive portfolio management lies in their strategies: active
management seeks to achieve higher returns through market timing and stock selection, while passive
portfolio strategy focuses on long-term growth by mirroring index performance. By grasping the

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difference between active and passive portfolio management, investors can choose the approach that
best aligns with their financial goals and risk tolerance.

Active management sounds good because it might give you more money in the end and lets you make
specific choices. However, passive portfolio strategy is simpler, cheaper, and you just follow the market -
if in the long term the market grows (which we mostly expect it to), then passive portfolio strategy will
also give good returns. Understanding the difference between active and passive portfolio management
can help you decide between the 2. Ultimately it will depend on how much risk you're comfortable with,
what you want to achieve, and if you think active or passive portfolio strategy work better.

● Factors to Consider in Choosing Between Passive and Active Management

a) Investment Goals
Passive management is suitable for long-term investors that want stable growth at lower costs.
Active management is more appealing to those looking for higher returns and want more
involvement in the investing process.

b) Risk Tolerance
Passive management aligns better with risk-averse investors, while active management is more
suited for individuals who are willing to take on higher risk for potentially higher rewards.

c) Time and Involvement

Passive strategies needs less monitoring and less involvement - suitable for investors with less
time or interest in active decision-making.

d) Market Conditions
Active management may perform better in certain market conditions, such as periods of high
volatility or when market inefficiencies are more pronounced.

● Decision between Active or Passive Investing

Whether you decide between passive or active portfolio management comes down to what you
personally like, how much risk you're okay with, and what you want to do with your investments.

In short, passive management is good if you want something simple, diverse, and affordable. It works
well for people who want their money to grow in the long run without the need to make a lot of
active choices. Active management is for people who think skilled managers can do better than the
regular market.

The choice should really match what you want to do with your money, how long you're planning to
invest, and how comfortable you are with it. You can even use a mix of both strategies in your portfolio
to get the benefits of both.