Enhanced Passive Management
Striking a Balance between Efficiency and Opportunity
Enhanced passive management is a nuanced portfolio management strategy that bridges the gap between passive and traditional active investing approaches. The strategy has gained prominence in the world of asset management due to its ability to offer investors a middle ground – harnessing the efficiency and cost-effectiveness of passive investing while still being dynamic and active enough to take advantage of opportunities to enhance returns.
Before we jump into what enhanced passive management is and how you can incorporate it into your equity management approach, let’s discuss the two key components of the strategy first.?
What is Passive Management??
Passive management, often referred to as passive investing, is a strategy that involves constructing and managing an investment portfolio with minimal active decision-making.?
The primary characteristic of passive management is the use of index funds, via the use of exchange-traded funds (ETFs) or traditional managed funds, that aim to replicate the performance of a specific market index, such as the S&P 500 or the ASX200.?
The key benefits of passive management in financial advice include lower costs, reduced portfolio turnover, and a focus on long-term, buy-and-hold investing. Passive investors believe that, over the long run, markets tend to be efficient, and it can be challenging to consistently outperform them through active trading. Instead, they opt for a more hands-off approach, seeking to achieve market returns while keeping investment expenses to a minimum.
Passive management can be an excellent fit for investors who prioritise simplicity, lower fees, and maintain a comparatively lower risk tolerance. It is particularly popular for those who prefer a "set and forget" approach to portfolio management, as it minimises the need for continuous monitoring and decision-making.?
What is Active Management?
Active management refers to an investment strategy that involves making active buy/sell investment decisions with the aim of achieving returns that surpass a particular benchmark. Unlike passive management, which seeks to replicate market performance, active management relies on the expertise of professional portfolio managers or financial advisors to actively buy and sell assets based on their assessment of market conditions, economic trends, and individual security analysis.
This approach is characterised by a dynamic, hands-on approach to portfolio management. Active managers engage in thorough research, analyse individual securities, and monitor market conditions closely to identify investment opportunities. They adjust portfolio holdings as necessary, making tactical decisions that are expected to yield superior returns. The ultimate goal of active management is to generate alpha, which represents the excess return earned above the performance of the chosen benchmark. Active management is attractive to investors seeking a personalised and proactive investment strategy.?
It is important to be aware that this approach typically involves higher costs, greater portfolio turnover, and the risk of underperforming the market due to the unpredictability of financial markets.?
In comes … ‘Enhanced Passive Management’
At its core, enhanced passive management acknowledges the widely accepted notion that passive investing, can be an effective way to build a diversified and low-cost portfolio. However, enhanced passive management takes this concept a step further by recognizing that there are ways to optimise returns without fully embracing active stock selection.
This investment management strategy allows investors to effectively cap their relative under/out performance with a component of the portfolio always retaining index exposure and subsequently index returns. This ensures an element of the portfolio generates always market returns providing a support line for portfolio performance. This is then complimented (and ideally enhanced) by an exposure to direct or factor tilted investments that have been identified as offering above market investment fundamentals, exposing the portfolio to potentially superior returns relative to the market.?
Smart Beta Strategies: The Engine of Enhancement
A simple way to deploy an enhanced passive management approach is the integration of smart beta strategies. Smart beta, also known as factor-based investing, is a systematic approach that selects and weights stocks within a portfolio based on specific factors or characteristics. These factors can include things such as value, quality, momentum, size, low volatility, dividend yield, etc. By systematically tilting the portfolio (increase the weighting) towards these factors, enhanced passive managers aim to outperform traditional market-capitalization-weighted indices without resorting to traditional stock picking. The manager is in effect taking a position that the nominated factor will be an above market contributor to total index returns as opposed to an individual stock out performing. ?
Let’s expand on some of these factors…
Value: Value-focused enhanced passive strategies identify stocks that are undervalued based on fundamental metrics like price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, or dividend yield.?
Quality: Quality-focused strategies select stocks of companies with strong financial health, stable earnings, and consistent profitability. These firms are believed to be more resilient during market downturns, reducing portfolio risk.
Momentum: Momentum strategies allocate assets to stocks that have shown strong recent price performance. The underlying assumption is that trends tend to persist in the short to medium term, and these stocks may continue to perform well.
Low Volatility: Low volatility strategies seek to invest in stocks that historically exhibit lower price fluctuations or lower beta compared to the overall market. This factor aims to reduce overall portfolio risk, especially in turbulent market conditions.
What are the Benefits of Enhanced Passive Management?
Enhanced passive management offers several benefits that appeal to investors seeking a balanced approach to investing:
Cost-Efficiency: Enhanced passive strategies often come with lower fees compared to entirely actively managed portfolios. With less turnover within the portfolio, transaction costs are minimised over the long term. One thing to consider in this regard however is the management expense ratio (MER) often present through the use of diversified products.?
Systematic Approach: Enhanced passive strategies are largely rule-based and systematic, reducing the reliance on individual manager skill and subjectivity. This transparency and reduced exposure to personal bias’ can be appealing to investors.
Potential for Outperformance: By integrating smart beta factors and direct holdings, enhanced passive strategies have the potential to outperform traditional passive strategies over the long term.
Risk Management: Smart beta factors like low volatility and quality can contribute to risk reduction, making enhanced passive portfolios more resilient during market downturns.
What are the key Risks and Considerations?
Tracking Error: Enhanced passive strategies may deviate from traditional market indices, leading to tracking error. Investors should be comfortable with these deviations and understand the potential impact on returns.
Factor Risk: Depending on the factors used, enhanced passive strategies may be exposed to specific factor risks. For example, value-focused strategies may underperform during periods when growth stocks dominate the market.
Overfitting: The design of smart beta strategies requires careful consideration to avoid overfitting historical data. Strategies that work well in the past may not necessarily perform as expected in the future.
Research and Due Diligence: Investors should conduct thorough research and due diligence when selecting enhanced passive strategies or managers, as the effectiveness and returns of these strategies can vary.
Enhanced passive management represents a compelling approach to portfolio management, combining the cost-efficiency and relatively lower risks of passive investing with factor or corporate tilts within the portfolio to potentially enhance returns. By incorporating smart beta factors and direct investments, this strategy seeks to strike a balance between efficiency and opportunity, making it an attractive option for investors looking to optimise their portfolios and generate long term, compounding returns.?
If you are after more information about enhanced passive management, or you would like to know what a personalised portfolio for your circumstance could look like, I encourage you to reach using the detailed listed below.?
Louis Dooley
+61 459 481 512
07 3245 5466
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