Question

(b) A recent headline read: "Nine out of 10 active funds underperform benchmark", Financial Times, October 26, 2015. Critically appraise the arguments as to whether fund managers should therefore use purely passive investment strategies or whether investors should use, for example, a combination of active and passive strategies or "smart beta" strategies when constructing a portfolio. (13 marks)

Answer 1

Active investment strategies require the professional expertise of a seasoned portfolio manager. Passive investment strategies involve simultaneous buying and selling of index or other mutual funds. Passive investment strategies have a better historical record of generating returns compared to active investment strategies which have performed very well in 2019.

Passive investment strategies consider the index as their benchmark leading to more transparency and are more tax-efficient as the simultaneous buy and hold strategies don't lead to significant capital gains. However, they are limited by the number of indexes monitored by them and do not provide windfall gains compared to the market, unlike the active investment strategy.

Active investment strategies are relatively more flexible as they do not monitor any particular index. The managers can also protect their investment from risks through futures and options. They can also enter or leave a particular sector or index as per their wish, unlike the passive investment managers. While the active investment strategies might lead to windfall capital gains or losses but the managers may guide the investors to sell their investment when it is losing money. All the advantages translate into higher costs associated with the funds associated with the multiple transactions and also come with higher risks.

Smart beta strategies refer to the combination of the positives of passive and active investing strategies. They employ alternative index construction rules as opposed to the conventional market capitalization-based indices. The strategy concentrates upon the investment factors or market inefficiencies in a disciplined and transparent manner. They may also adopt different weighting schemes like volatility, liquidity, quality, value, size, and momentum.

From the above points, it seems that fund managers should try and inculcate the advantages of all the three strategies and focus towards risk minimization of the approaches through adequate research and study related to the sector, industry and macroeconomic environment for the best results.