This report is going to evaluate and discuss about the investment managements- active investing and passive investing in several points of view. Passive management is completely an opposite investing strategy to active management. Passive managements are traded on a mechanical analysis by looking at historical data. It is based on the assumption of higher return over a longer period of time. On the other hand, active managements attempt to outperform by factor selection or market timing strategies. It seeks to maximise the market return in short term. However, there is no such a thing as a risk-free investment in the real world. Risk does apply to both active investing and passive investing.
Therefore, some major differences between passive investing and active investing are examined and compared in the body of the report. There are four points of view processed as follows. Firstly, efficient markets are relied for those investors who prefer passive investing strategies rather than active investing strategies. Secondly, active investing has to overcome some costs such as transaction costs, while it in fact costs less for passive investing. Thirdly, Fourthly, tracking error, which indicates that volatility of the difference between the performance of a replicating portfolio return and its benchmark index return, will be referred for overall performance. Under each heading, more detail are discussed and compared between those two investing strategies. Finally, conclusion comes to sum up the report.
2. Efficient Markets
In finance, market efficiency is one of the most contentious ideas. It is believed that the market is nearly perfect for companies. If the market is efficient, then the market prices are priced correctly according to all available information. Malkiel (2003) has stated that the market is efficiently adjusting and digesting to new information, which information is normally reflected in markets prices immediately.
Passive management is the preferred investing strategy for those investors who believe the markets are efficient. It is much more common on the equity markets, and it is becoming more generally widespread in other investment types. Ennis (2005) states that efficient market hypothesis (EMH) was evaluated few decades ago and was portrayed that the markets are quite efficient. Markets have reflected fair pricing instantaneously upon release of any good or bad price-related news. Fabozzi (1999) has pointed out that an investor believing in efficient markets tends to favour a passive strategy. Furthermore, efficient market hypothesis has nominated that equilibrium market prices completely reflect to all information, and information is spontaneously available in the efficient markets. In addition, a number of anomalies may exist in the efficient markets. Malkiel (2003) refers that the patterns of anomalies seem to be cleared away after discovered. The predictable patterns are not large and some are better for measuring risk rather than inefficiencies. As stated before, efficient markets are believed by those investors who pursue passive investing management.
In an efficient market, passive management plays a significant role to eliminate some specific certain risk by diversification. Specifically, there are two type of passive investing strategies suggested. According to Fabozzi (1999), in Investment Management, one approach is a buy-and hold strategy, which is to buy a portfolio of stock based on several criterion and hold them over some horizon of investment. The other one is index fund management referred as indexing. It is to create an index fund programmed to be replicating portfolio. Above all, using passive management is to minimise the investing fees and to avoid the adverse consequences of failing to anticipate the future correctly.
On the contrary, the markets are not always efficient in the real world. Fabozzi (1999) outlines that active management is…