What is active management?

Basically, this is the practice of stock (or sector) picking and market timing. By definition, active managers make a lot of trades. They seek to buy low and sell high – moving into favored stocks or sectors, and out of those they expect to decline – in the pursuit of above-average returns.

Active managers employ a combination of modeling techniques and human analysis to divine technical shifts and stock trends; when they do land on a winner, the results can be stunning.

What is passive management?

Passive managers take a much longer – and broader – view. Rather than rely on individual stocks or groups, they invest across broad sectors of the market, or indexes, comprising different "asset classes." Passive managers allocate or weight these classes on the basis of empirical data delineating risk vs. returns, diversifying widely (as widely as possible).

Once they've developed an asset allocation model, passive managers generally make trades only for the purposes of maintaining or re-adjusting the balance of that model in the pursuit of superior total returns, relative to risk, over time.

So the common term "passive" – vs. active – is something of a misnomer. Probably a better way to describe the difference is this: the active approach is "micro-management" of stocks, with a near-manic, day-to-day emphasis on picking, buying and selling individual winners and losers; passive management is a "macro-management" model. Managers keep a broad focus to encompass as many productive asset classes as possible, relying on overall performance.

Passive managers are so obsessed with diversification that they periodically rebalance their portfolios to ensure continued properly-weighted allocation.

Which approach works better?

It's ironic that many individual investors think the Big Money – with brilliant Ivy League analysts and powerful research-engines behind it – is able to expertly surf the stock markets, riding the backs of winners, while the smaller investors must settle for second-hand data and try to catch on where superstar managers have struck gold.

Actually the exact converse is true.

One study found that 40% to 50% of all institutional monies are invested in index or passive portfolios. Yet a relatively few "retail investors" make use of proven passive-management strategies. Analysts point to this disparity as another example of the chasm between professionals and the "amateurs" who become enamored of headline-grabbing fund managers.

We believe the reason is a simple lack of understanding.

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