Category :

Active and Passive Investing: Allies, not Adversaries

Yannis Sardis, 30 October 2020

‘The difficulty lies not in the new ideas but in escaping from the old ones.’
John Maynard Keynes, Economist Extraordinaire

The Debate

A massive amount of academic research, practitioner surveys and media coverage has been dedicated to address the heated debate between supporters of two types of investment style: Passive versus Active investing. If emerging investment flows are accounted for, the popular vote is loud: passive investments have been attracting record-breaking inflows, whilst active ones have been steady or experiencing incremental outflows.
It is not the purpose of our note to provide a definitive answer to this long-standing question. We can however rationally address the individual modules that compose the apparent dichotomy between these two investment approaches. A fact-based assessment can potentially affect your investment performance statistics in real terms.


Simply put, a passive investment strategy aims to closely track a broad market index (thus produce market beta) via a market capitalization-weighted methodology for its constituent holdings. Representative passive investment instruments include Index Funds and Exchange Traded Funds.
A departure from the market capitalization-weighted index construction is, in principle, deemed to be characterized as an active investment strategy. Such an approach often involves a rules-based methodology applied to the index constituents as well as a varying frequency of the index rebalancing. It may be based on an independent proprietary valuation of each portfolio constituent, aiming to outperform a standard benchmark (thus produce an excess return or alpha). There is a wealth of active investment strategies, ranging from Smart Beta solutions to complex hedge fund strategies.

Popular Perceptions

Passive investing is often presented as the domain for un-sophisticated investors, who speculatively chase returns for the lowest possible fee, by directly positioning their portfolio through passive index funds. On the other hand, active managers are often presented as glorified, market benchmark-trackers who often fail to beat a benchmarked index, charge elevated fees and who, on average, provide no more than market beta instead of the well-sought-after skill-driven alpha.
Are the above popular descriptions about both the definition of the investment strategies themselves and the practices of their managers accurate and representative of the way they could both contribute to an intelligent composition of a well-thought portfolio? We believe not.
Neither is the perception that these two strategy approaches cannot co-exist in a portfolio which seeks to tap into different sources of return and to concurrently risk-adjust its positioning in a way that will harness capital preservation.

Rethinking the Basics

What potentially makes a strategy passive or active is not only its weighting methodology or the frequency of its rebalancing schedule, but also the systematic approach that the portfolio manager utilizes to determine:

• When and by which weight a portfolio repositioning should take place
• When and by which weight one should ride position profits and/or cut losses
• When and by which weight beta- and/or alpha-generating instruments should be concurrently chosen,

in order to provide a diverse base of un-correlated (or not perfectly correlated) sources of returns as well as risk-cautious portfolio return enhancement.

Blend instead of Choosing

Both investment styles can play a critical role in one’s portfolio, as they historically tend to benefit portfolios in different market regimes. Investors should care about fees and trading costs as much as they do about portfolio liquidity or market risk and aim to construct an adaptive portfolio which can weather wild price fluctuations.

Depending on one’s investment idiosyncrasy, personal objectives and projected timelines, investors can combine both active and passive investing, across asset classes and instrument types, and benefit from the most valuable attributes of each to improve their returns. In periods of market stress, such a combined approach could improve outperformance or at least lower underperformance and help mitigate the overall portfolio risk, depicting profits in the light of the level of risks taken to achieve that returns.

Wealth managers would benefit from creatively thinking outside the box and avoiding portfolio assessment based on popular perceptions.

FINVENT Software Solutions is a provider of advanced financial software applications and custom engineering services. The award-winning KlarityRisk platform specializes in investment risk analytics and fixed income performance attribution reporting and it is offered to Private Wealth institutions, Asset and Hedge Fund Managers and Family Offices. Finvent is the sole SS&C Advent distributor worldwide and its products are integrated with those of SS&C Advent. Finvent is also a partner of FactSet, the integrated data aggregator platform.