How to allocate active and passive investing

Neither active nor passive investing style is an automatic winner; learn when to apply which and why.

Active or passive or a combination of both as an investment management style has been debated for decades. The house is divided, with no clear winners.

What are these styles and which is better or can one combine the best in both?

Active management (also called active investing) refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index. He is exploiting the market inefficiencies by purchasing securities he thinks are undervalued or by short-selling securities that are overvalued or both. Contrary to the popular belief, active management can also create portfolios with lower volatility (or risk) than the benchmark index.

Passive management (also called passive investing) is a financial strategy where a fund manager takes as few portfolio decisions as possible. The objective is to mirror the market returns, reduce the transaction costs, including the incidence of capital gains tax and eliminate the human factor in the management as much as possible. One of the most popular methods is to mimic the performance of externally specified market indices, by investing the money in securities in the same percentage of holdings as they are in the index. These are popularly known as Index Funds. Basically, an index fund manager is not supposed to do anything but just sit tight. There are a plethora of market indices and thousands of different index funds tracking many of these.

Advantages of both
The primary attraction of active management is to allow selection of a variety of investments, instead of investing in the market as a whole. It allows investors to follow a strategy that avoids or underweights certain industries, compared to the market as a whole, and may find an actively-managed fund more in line with their particular investment goals. Based on the analysis, one can create a portfolio of only those stocks likely to perform better, not carry deadweight.

The primary attraction of the passive style is its ability to allow participation in the market without dependence on the investment manager's ability and a strong belief that the markets are efficient enough to capture returns over a period of time. Due to its passive nature, this style is far less expensive both in terms of management fee & expenses and also the incidence of capital gains tax.

Disadvantages of both
The most obvious disadvantage of active management is that the fund manager may make bad investment choices or follow an unsound theory in managing the portfolio. The fees are also higher, even if frequent trading is not present. Active fund management strategies that involve frequent trading generate higher transaction costs which diminish the fund's return. In addition, short-term capital gains also eat away a good chunk of returns.

The most obvious disadvantage of passive management is that at times, even if you do not want to participate in a particular stock or sector, you end up participating by investing in the index funds. The index you have invested in may be more volatile or risky then your own risk taking ability. In an emerging market like India, this may not be the best solution at all times, as you may miss out on some growth stories.

What should I do?
Since there are merits and demerits in both styles, a better way may be to marry the best of both. This will ensure the inefficient stocks you do not want to invest in will not be part of your portfolio and you still participate in the broader market. The challenge is to reduce the transaction cost and also the capital gains tax and still participate in the markets and enhance wealth creation over a period of time. One way to do it is by investing through more cost-efficient & transparent vehicles like an exchange traded fund and invest in portfolios which are active, but passively.

Both styles have survived for many years and will continue to do so. In the ever changing world, the challenge is to create a style that combines the best of both the world.

The writer is CEO of Motilal Oswal Asset Management Company