Equities represent a substantial part of global investments. It offers various advantages to both organizational and individual portfolios. These advantages include capital growth, diversification with other asset types, dividend income, and potential protection against inflation. Equity portfolios tend to exist across a passive-active spectrum, ranging from those that closely follow a market benchmark to those that are not tied to any specific index. The latter are often managed by professional portfolio managers or investment firms, and their performance is often compared to a general broad market index to gauge their excess returns. Portfolios can take many forms, such as open-ended mutual funds, ETFs, smart-beta portfolios, or long-short portfolios. There are several reasons why an investor may select a portfolio along the passive-active spectrum.
Passive-Active Spectrum
Investing in equities is often guided by a client’s specific goals. Asset managers typically take into account important investment objectives and constraints, such as risk tolerance, desired returns, liquidity needs, investment time frame, tax considerations, and any unique circumstances. Equities are frequently categorized by size, style, geography, and economic sector. Consequently, there are relevant benchmarks for equities in the same category. These benchmark indices usually weight equities based on their market capitalization.
In certain groups, like large-cap companies from developed markets, firms are well-established and receive extensive coverage from financial analysts. Due to their significant market capitalization, all publicly available information is thoroughly analyzed and typically reflected in their stock prices. This reduces the chances of achieving excess alpha, diminishing the need for an active portfolio manager in these groups. Consequently, these portfolios are mostly managed passively with infrequent rebalancing throughout the year.
On the other hand, for equity groups such as mid-cap and growth stocks, or equities from emerging markets, having a professional portfolio manager is crucial. These managers actively analyze the equity mix and may rebalance the portfolio more frequently, like monthly or even weekly. This rebalancing process involves adjusting capital allocation and often includes adding new stocks or removing existing stocks to meet the risk and return objectives.
The table below illustrates various investment themes within the passive-active spectrum of equity portfolios. In certain categories, equities are entirely managed actively, whereas in others, there are mainly managed passively.
Active Investment
Several ETFs are available to track standard indices, serving as straightforward forms of passive investment. An index fund that mirrors its benchmark requires minimal rebalancing. Client preference plays a crucial role in choosing between passive and active investing. Additionally, investors’ beliefs about the potential of active strategies to generate significant excess returns are important, given that active management is generally more costly than passive management. Investors must weigh the benefits of achieving excess return against the additional costs. The table below highlights various cost components linked to active funds.