Strategic Implementation Choices

Passive Vs. Active Management

In investment choices, investors have the initial question of whether their investments should be passively or actively managed. Passive management refers to tracking the performance of various indices, such as the S&P 500, and not making any further changes to the portfolio unless the index changes in weight. This is like a “do nothing” or buy-and-hold strategy.

On the other hand, active management refers to making periodic adjustments to a portfolio to look for opportunities to outperform passive management—at least on a risk-adjusted basis. Examples could include sector rotation and timing or using fundamental analysis to purchase under-valued securities.

Strategic asset allocation: This is allocating money to IPS-permissible asset classes that integrates the investor’s return objectives, risk tolerance, and investment constraints with long-run capital market expectations.

Tactical asset allocation: This involves a short-term deviation from strategic asset allocation to improve risk-adjusted return.

Dynamic asset allocation: This is similar to tactical asset allocation but instead incorporates a long-term set of market expectations rather than short-term ones.

Factors Affecting Passive vs. Active Decision

• Available investments: The availability of an investable and representative index is necessary for indexing.
• Scalability of active strategies being considered: The value added by an active strategy may begin to decline at some level of invested assets. Also, participation in a strategy may not be available below some asset level, a consideration for small investors.
• The feasibility of investing passively while incorporating client-specific constraints: By way of example, an investor’s particular environmental, social, and corporate governance (“ESG”) investing constraints may not line up with existing index products.
• Beliefs about market informational efficiency: A strong belief in market efficiency for the asset class(es) under consideration would steer the investor away from active management.
• The trade-off of expected incremental benefits relative to incremental costs and risks of active choices: Costs of active management include investment management costs, trading costs, and turnover-induced taxes; these costs would have to be assessed relative to the lower costs of index alternatives, which vary by asset class.
• Tax status: All else equal, taxable investors would tend to have higher hurdles to profitable active management than tax-exempt investors.

Risk budgeting refers to analyzing risk and deciding how much and what risk the investor would like to take. With risk comes reward, so the goal is never to eliminate all risk but to understand and manage risk in the most intelligent way possible.

Risk budgeting also presents another method of asset allocation. Rather than viewing the securities by their designated asset classes, a portfolio may be constructed to meet specific desired risk metrics of the portfolio.

Active risk budgeting refers to viewing a benchmark and deciding how much extra risk concerning that benchmark the investor is willing to take on to outperform that benchmark.

Question

Which of the following is most likely why an investor might choose active vs. passive investment management?

When the investor has:

1. Non-taxable accounts only.
2. No ESG constraints.
3. Multiple available representative and investable indexes.

Solution

The correct answer is A:

All else equal, taxable investors tend to have higher hurdles to profitable active management than tax-exempt investors. In other words, non-taxable investors can benefit more from active management than taxable investors due to the higher turnover of active strategies.

B and C are incorrect as they are in favor of passive management. If there are few or no constraints, the investor can replicate a wide range of investments as represented by an index. Having multiple appropriate and usable indexes is also a situation that adds to the feasibility of passive investing. 

Reading 4: Overview of Asset Allocation

Los 4 (i) Discuss strategic implementation choices in asset allocation, including passive/active choices and vehicles for implementing passive and active mandates