Equity Investment Across The Passive–Active Spectrum

The choice between managing a portfolio of equities passively or actively involves various minor decisions. The result is not strictly a binary yes-or-no answer. Instead, it can be viewed as a decision that falls along a spectrum. This decision-making process encompasses a range of options, and even the individual sub-criteria within it allow for considerable variation.

The following aspects help inform the active vs. passive decision:

Confidence in Management

Investors who have faith in active management are often willing to bear the additional costs it entails. Though there’s an ongoing debate about whether active management justifies these costs, specific clients hold strong confidence in their management teams and believe in the overall effectiveness of active management.

Growth Vs. Value

Both growth and value investing can be managed actively or passively. Growth investing is often associated with active management due to the need for in-depth analysis and trend identification. In contrast, value investing is more aligned with passive strategies which can involve replicating passive indexes to capture value opportunities.

Client Constraints

Client-imposed constraints outlined in an Investment Policy Statement (IPS) can impact the management approach. For instance, if a minimum percentage of the portfolio must be invested in blue chip stocks, this favors passive strategies. Blue chip stocks usually trade in efficient markets due to their size, stability, and extensive analyst coverage.

Furthermore, Environmental, Social, and Governance (ESG) constraints tend to favor active strategies. Meeting specific ESG criteria, such as a minimum annual carbon emission threshold, requires additional analysis and may lead to active stock selection.

Drawbacks of Active Management

As explained earlier, active management tends to incur higher costs and offers less predictable performance. Portfolio managers adopting active strategies face the following risks:

• Reputational risk: Active management introduces more complexities, such as unique client agreements, significant regulatory considerations, and potential conflicts of interest.
• Key person risk: This risk involves the possibility of a crucial portfolio manager leaving the fund, impacting its performance and continuity.
• Higher portfolio turnover: Frequent transactions in a portfolio can lead to increased tax liabilities and the need for more precise tax management. This requires portfolio managers to possess additional tax expertise raising the risk of non-compliance with local tax regulations.

Question

Security correlations and market volatility most likely have the following relationship:

1. Inverse.
2. Positive.
3. Mostly stable.

Solution

The correct answer is B:

Competition among securities rises during market crises, dampening the diversification benefit.

When markets experience panic, and numerous security prices decline, they become more closely correlated as they all tend to drop simultaneously. Therefore, both volatility and correlations rise concurrently, indicating a positive relationship.

A is incorrect. An inverse relationship would mean that as one variable goes up, the other goes down, and vice versa. This does not accurately describe the relationship between security correlations and market volatility in the context mentioned above.

C is incorrect. It doesn’t capture the dynamic relationship between security correlations and market volatility, as it suggests a constant or unchanging relationship, which is not the case.

Portfolio Construction: Learning Module 1: Overview of Equity Portfolio Management; Los 1(e) Describe rationales for equity investment across the passive–active spectrum